Economic evaluation of an oil and gas project not only helps determine the economic feasibility but also plays a critical role in decision making. It, typically, starts with the derivation of net after tax cash flow starting from the present day and finishing at some time in the future.
The cash flow projections, as mentioned at the beginning, are required to assist us to decide whether or not the project ought to be undertaken. Cash flow projects lead to the calculation of economic indicators that provide an insight in the return from a project. The article highlights some of the important economic indicators used in the Oil and Gas industry to compare projects and make investment decisions.
Some of the most common economic indicators are:
- Net Present Value (NPV)
- Internal Rate of Return (IRR or ROR)
- Payback period
- Capital Productivity Index (CPI)
- Maximum Exposure (ME)
Time value of money and Net Present Value (NPV)
The investments and return in an oil gas project could have a large time gap and hence it is of paramount importance to compare the investment and revenue only by bringing them to the same time line. The concept of present value (PV) of money is very important to understand and analyze the economic indicators. The present value of money is equivalent value today of a sum of money received or spent some time in the future.
The section below taken from Guy Allinson’s book on Economic Indicators.
“The basis for the calculation of present value is the existence of interest – interest which can be earned by putting money into the bank or into some other investment. This is best explained by means of an example.
Suppose that $100 is placed in a bank account which earns interest at 10% per year. The value of the $100 after one year will be $110 and, if required, this $110 can be withdrawn from the bank. The $110 is calculated as follows:-
Future value of $100 after 1 year = $100*(1+10%) = $110
This calculation shows that, after one year, the original $100 is still there, but, by leaving it in the bank, interest of 10% of $100 (equals $10) has been earned. Adding the interest of $10 to the original amount gives $110. In this case $100 is compounded forward at an interest rate of 10%. Diagrammatically, the process of compounding interest can be represented as follows:-
Another way of looking at this is that $100 today is equivalent to $110 in one year’s time. In other words, the future value of $100 is $110. Therefore, future values are obtained by compounding at a given interest rate.”
The equation to calculate the present value is:
PV = FV/(1+r)^n
Where:
PV = Present Value
FV = Future Value
R = interest rate or discount rate
Please note that the NPV at discount rate of 0 is undiscounted and NPV is effectively same as the net cash flow.
The NPV value helps in making investment decisions. The general rule adopted when using NPV is that the project should be undertaken if the NPV is positive at a discount rate representing the return which can be obtained from alternative investments.
If the NPV is negative, then the project should not be undertaken. To maintain consistency, nominal cash flows (inflated) should be discounted using the nominal discount rate and the real cash flows ( deflated) should be discounted using the real discount rate.
Internal Rate of Rerun (IRR or ROR)
Mathematically, the discount rate at which NPV becomes 0 is called as Internal Rate of Return for that project. This is the discount rate for which all discounted negative cash flows are equal to all discounted positive cash flows.
The picture below (Taken from Guy Allinson’s book) depicts the calculation of IRR:
As a rule of thumb, higher the IRR better the project. While comparing multiple investment opportunities, the project with higher IRR should be given preference.
Capital Productivity Index (CPI)
CPI is defined d as the net cash flow of the project per dollar of capital investment. It, primarily, is a measure of by how much the project’s cash flow covers the initial investment. The CPI can be calculated by using the formula mentioned below:
CPI = Net cash flow/Capital investment
The CPI can also be calculated for the discounted cash flow and discounted capital investment. The projects that have a CPI greater than 0 are typically a good project. CPI indicator can also very well used in the process of capital rationing. One of the drawbacks of CPI is that unlike NPV we cannot add or subtract CPI because it’s a ratio.
The picture below (Guy Allinson – Economic Indicators) summarizes and compares the different economic indicators:
