Investment and decision analysis for petroleum exploration


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Investment and decision analysis for petroleum exploration is a subject that many explorationist, geologist, management accountant and finance manager likes to know about. This paper shows the major concepts of how investment, decision and project analysis is made for petroleum exploration in financial view that is based on cash-flow models and applying capital budgeting techniques per International Oil and Gas business, financial and contractual arrangement that impact on such analysis. This paper does not cover such analysis in technically view because it is out of specialization, but this analysis shall be made in conjunction with technical experienced staff.
Keywords: Investment and decision analysis for petroleum exploration, Project Analysis for Petroleum Exploration

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  • This paper discuss the key concepts of investment in petroleum exploration and how to take a decision for petroleum exploration alternatives. Also, the helps to make drilling well project analysis.
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Investment and decision analysis for petroleum exploration

  1. 1. Management And Financial Accounting In Oil and Gas Upstream Industry. Investment and Decision Analysis for Petroleum Exploration & Production Hamdy Rashed, CMA; CAPM Bsc of Accounting, E-mail:, Dated on July 10, 2012AbstractInvestment and decision analysis for petroleum exploration is a topic that manyexplorationists, geologists, management accountants and finance managers like to knowabout. This paper shows the major concepts of how investment, decision or project analysisis made for petroleum exploration in financial view. Such analysis depends on cash-flowmodels and applying capital budgeting techniques per International Oil and Gas businesspractices that consider accounting concepts, taxation, and contractual arrangement thatimpact on such analysis. This paper does not cover such analysis in technical view becauseit is out of specialization, but this financial analysis shall be made in conjunction withtechnical experienced staff to obtain some technical information of estimated reserves,estimated initial production, chance of success and others to enable Company to prepareinvestment and decision analysis.Keywords: Investment and decision analysis for petroleum exploration; Project Analysis forPetroleum Exploratio;, Present value of net cash flow in future for reserves, fair value ofexploration license.For Petroleum investment, decision or practices, the major risks that can be facedproject analysis, we need to consider the by Oil Companies, the input and output ofhome country taxation, production sharing the investment and decision analysis.and joint interest arrangements, andenvironmental legislations. It is preferred to Major aspects of Production-Sharingdivide this paper into some sections; the first Systemtwo sections that brief the major aspects of Presenting the major aspects of productionProduction Sharing Agreement (PSA) and sharing contracts enable managementJoint Operating Agreement (JOA), the major accountant to know how the cash flowaspects of taxation, and accounting analysis should be processed. 1 
  2. 2. Exploration and Development exploration period as minimum expenditureMany fiscal regime in Middle East and obligation.Africa divided the periods of the ProductionSharing Agreement’s (PSA’s) into a) For each exploration period, Contractor shallExploration phase that is most likely divided deliver irrecoverable letter of credit thatby two periods; first exploration period; covers the minimum expendituressecond exploration period, each having obligation, that is reduced when thespecified minimum exploration obligation Contractor meet the minimum expenditureand expenditures that must be conducted obligation. Most of oil companies spendwithin specified time limit. Each exploration exploration cost that exceeds the value ofperiod takes about between 2 and 3 years minimum work commitment.that can be extended from 6 months to 2 Annual Work Programyears. b)Development phase is commencing Subject to the provisions of PSAs, the multi-of the first Commercial Discovery of company shall conduct the requiredOil/Gas and continue for a period of 20 exploration activities during the Explorationyears and can be extended by up to 5 Years period of Exploration work program cannotmore. be changed or amended without the approval of host government. The Exploration workWork CommitmentWork commitment is always indicated in should be fulfilled even if it exceeds thePSAs that covers the minimum work Minimum Expenditure Obligation.obligation and minimum Financing & Technologyexpenditure/financial obligation during the The Contractor provides all the requiredexploration period. The Multi-company is financing and technology in according to theobligated to conduct the following minimum work obligation in the PSA, andExploration work during the Exploration multi-company bears all the risks solely.Period: Relinquishment and Assignment a) Seismic Data that are generally There is requirement to relinquish certain measured in kilometers of 2D or 3D portion of the exploration area at the end of seismic lines to be acquired, the first exploration period and totally processed and interpreted or relinquish at the end of the second reprocessed the available data. exploration period. The area to be b) G&G studies relinquished at the end of the first exploration is about 25% of many of PSAs. c) Drill and evaluate number of The multi-company has the right to exploratory and appraisal wells. withdraw before end of the first exploration period but has to fulfill the minimum workProduction Sharing Agreement determines many dollars are spent during each 2 
  3. 3. Any assignment by any partner license of all expenditures that is computed based byor part of its interests shall be subject to multiply Base factor (that is determined atspecific rate of the Net Sales Proceeds that indicated levels of average total dailyshall be paid to host government in some production) by A factor (that is determinedPSAs. by indicated ratios of cumulative value of production received by contactor)Bonuses PaymentBonuses are paid upon signing the Non-Recoverable CostProduction Sharing Agreement that is called In the fiscal system, there are someSignature bonus which is varied in dollars expenditures is non-recoverable from oildepend on the prospectively of the contract production such as signature bonus, fixedarea, competition and negotiation. Also, tax and costs and expenses not relatedContactor shall pay annual bonuses to the directly or indirectly to Petroleumhost government. Kurdistan PSAs consider Operations such asthe annual bonus as recoverable costs butYemen PSA does not. Also, first production 1) Losses which are recovered throughbonus is paid after the first tanker lifting of insurance, any contract of indemnitymulti-company’s share, , and pays another 2) Specific bonuses paid to hostamount of production bonus that is based on governmentthe daily production scales or cumulative 3) Interest, fees and commissions onproductions depends on PSAs, this bonus in loans and guarantees.non-recoverable in most PSAs. 4) Exploration and production rentals. 5) Expenses incurred and paid for theProduction Sharing Oil marketing of Crude Oil from theThe remaining of crude oil or natural gas Agreementafter deducting royalty and cost oil from thegross average daily crude oil produced and Cost Recoverynot used in petroleum operations, is All the following costs and expenses will becalculated based on scales that the recovered to the multi-company by Oil Cost:government portion is increased if the a) Operating expensesaverage daily production is increased suchas Yemen and Tanzania PSAs or based on b) Exploration expenses that includeR-Factor that government portion is but not limited to, those accumulatedincreased if R-factor increased by increasing prior to commencement of initialthe cumulative net revenue obtained by commercial production that shouldsubcontractors to the cumulative cost spent, be recoverable at specific rate.R-factor is applied per Tunisian PSA, c) Development expenses that includeKurdistan PSA. As per Libyan PSA, multi- but not limited to, those accumulatedcompany is entitled to crude oil in prior to commencement of initialpercentage determined for cost recovery commercial production that shoulduntil cumulative value equals cumulative be recoverable at specific rate. 3 
  4. 4. If all costs, expenses and expenditures that For the income tax on Multi-company’sare recoverable in any Quarter, exceed the income, the income taxes will be paid by“Cost Recoverable Ceiling”, it shall be host government on behalf of the Contractorcarried forward for recovery in the next and not be charged against the company.succeeding Quarter or Quarters until fullyrecovered, but in no case shall be recovered Major aspects of Interest and Operationafter the termination of an Agreement ArrangementsAdministrative Overhead Joint Operation AgreementMulti-Company is compensated its The type of interests between partners ratheradministrative overhead for tasks performed than government that is Working Interest oroutside host government, that is applicable (Joint Operating Interest) which is theto Petroleum operations under the PSA. interest in the oil and gas in place that bearsSuch overhead can be recovered but within most or all of the cost of exploration,specific limits which shall be calculated by development and operation of the property.multiplying the applicable sliding scale The Contractor partners will bear the costpercentage stated times the total year-to-date and the partners share the profit oil exceptexploration recoverable costs and/or specific for public corporation of host governmentagreed rate times the development, that does not bear the cost.production and decommissioning costs inmost PSAs. The Multi-company is not Direct Chargesallowed to recover more than the limited Operator will charge or credit Joint Ventureamounts stated in PSAs. accounts for all expenditures or credits incurred or received in conducting JointCorporation Share Operations.Many PSAs in Middle East require theMulti-company to carry The Public Indirect ChargesCorporation of a host government that shall An indirect charge is to compensatenot receive any cost oil, but acquires specific Operator’s parent affiliate in Home Officerate of the profit oil. and its affiliates, for its administrative contributions of performing services notHost government Taxes chargeable under direct charges for thePSAs exempt multi-companies from any benefit of Joint Operations. The Indirecttaxes and levies except for some specific charge is calculated by multiplying thetaxes such as fixed tax on exploration applicable sliding scale percentage stated inexpenditures in some country such as Joint Operation Agreement times the totalYemen, withholding income taxes on local Joint Account costs excluding some specificstaff salary, some PSA exempt the expenses. The operator cannot beexpatriate’s salaries from taxes but other compensated more than the limited amountPSAs impose taxes on expatriate’s salaries of overhead that is allowed by JOA.during development phase based on hostgovernment taxation. 4 
  5. 5. Farm-out/Farm-in/Carrying Interest allow taxpayers to deduct the foreign taxAgreement payments, but not exceeding the tax limits,The Farm-out obligation is either overriding other countries have no limits.royalty, retained interest, carved-out interest,net profit interest or neither. The most farm- Calculating the preliminary taxes that shallout agreement in some Middle East is to be paid is important for investment analysis.transfer the rights and obligations from Management Accountant needs to have thetransferor to transferee and the transferee key concepts of taxation of the residentwill become working interest partner for country. In our paper we will display the keyspecific interest rate, and in condition to pay concepts of most international taxation. TheFarmor specific amounts to transfer part of income tax that is paid by host governmentthe its working interest to Farmee. The on behalf of Multi-company is notAmounts that Farmee should pay them considered tax credit, exemption oreither is related to planned well or all deductions because multi-company does notprevious costs were previously paid by pay such taxes in most international PSAs.Farmor based on the assigned workinginterest, or/and specific amount whenproducing the first discovery. Taxation Most of multi-companies’ net income areCarrying Interest is used specially between subject to between 30-40% corporate taxAgent or Sponsor of Contractor/multi- to transfer part of working interestfrom assigner to assignee in condition that In most international taxation, Corporatecarried party (assignee) either pay specific should reach to taxable income, it shouldamounts presently or not pay any amount immediate deduct, and not immediateuntil license become productive then deduct;working interests will revert back to thecarried party when carrying party (assignor) Corporate should not immediate deduct thereaches payout. following: 1) Some expenditure, such as the costMajor aspects of Investor’s Country of acquiring capital assets, isPrevailing Laws: generally not deductible that isDouble taxation occurs when countries have depreciated over the economical lifedifferent definitions of taxable income and of rate, it rises when taxpayer is resident in 2) development drilling for petroleumforeign country and generates income in and facility costs which isanother country such as host country. Relief depreciated over the economical lifefrom double taxes comes in three basic of reserves;forms; exemption; tax credits; and 3) Cost of a depreciating asset.deduction. In some countries income tax, Depreciating assets are assets with a limited effective life that are 5 
  6. 6. reasonably expected to decline in 4) Environmental protection activities. value. Some states have cost threshold for Also, the Corporate that produce and sale assets that are to be considered as crude oil, may be subject to Crude Oil depreciating assets. Excise Rates, ad-volerum, production or sale 4) Also, some countries, e.g. U.S and tax rates. Canada divided development costs into Tangible Drilling Cost (TDC) Financial and Management Accounting that are depleted over the economical Practices life of reserves and Intangible Drilling Cost (ITD) that may part of Depletion, Depreciation & Amortization it is amortized over period of time. (DD&A) Both reserves and production/sale data areDepreciating assets include such items as used for calculating Depletion. Depletioncomputers, electric tools, furniture and calculation include only the portion of totalmotor vehicles. Depreciating assets proved or proved developed reserves andexcluded from the UCA; depreciating assets production that the working interest owner isthat are capital works – for example, entitled to.buildings and structural improvements for Book Value end of period Production forwhich deductions are available under the Estimated Reserves at X periodseparate provisions for capital works or beginning of periodwould have been available if the assets had The following Capital Expenditures aremet certain conditions for the deductions. allocated over years by computing Depletion.Corporate can immediate deduct the a) Development Costfollowing: b) Facility Cost 1) exploration or prospecting G&G c) Acquiring Cost costs except for acquiring acreage Depreciation is calculated for depreciating that includes: a. geological, geophysical and assets. Amortization is calculated for part of geochemical surveys; And intangible drilling cost that should be any G&G study costs except amortized not more than 5 years for for acquiring license. domestic integrated producer and no more b. Exploration well costs that than 10 years for foreign intangible costs per found no commercial oil U.S tax, and part of it is immediate c. feasibility studies to evaluate expensed. However, GAAP require the the economic feasibility of mining minerals or quarry company that follows successful effort materials once they have method to expense any costs that are not been discovered; determination of proved reserves and 2) Workover and Operating costs capitalize otherwise. 3) rehabilitation of mine and quarry sites; and; 6 
  7. 7. Asset Retirement Obligation such lease before signing theAsset Retirement Obligation is future Production-sharing contract withdecommissioning costs were estimated and government. Acquisition costs isit is treated as reduction of future net cash capitalized, but not recovered fromflows. Some PSCs such as Kurdistan require oil cost as per some PSAs. This costContractor to start depositing a funds and is depleted over the life of netmaking provision for decommissioning Contractor’s share of oil reserves.costs before the end of productive contract This cost is considered as initialby 10 years. investment if new acreage will be acquired, but shall be considered asOperating Expenditures sunk costs if the acreage is alreadyThis cost is called OPEX that is referred to acquired and Company needs toLease Operating Expenditures which are make project analysis for otheroccurred periodically and are necessary for activities.the day-to-day operations of the field. In thefeasibility study and cash-flow model, such b) Geological & Geophysical Studiescosts are usually expressed per year per G&G cost are pre-drillingbarrel. It consists of two elements 1) indirect exploratory well; this cost includescost; 2) direct cost per production level. topographical, geological, geophysical, geochemical costs. InOpex include cost of manpower; utilities and accounting standards, the Companymaterials that are consumed for operation which use successful efforts method,activities; credits of co-products; expense such cost except the G&Gadministrative and general expenses spent that is related to acquiring acreage isfor operations activities; maintenance of capitalized as acquisition cost, andfacility equipment; lifting cost; treatment the Company which uses the full costcost and insurance cost. method, capitalize such cost. ForCapital Expenditures feasibility study of investment orThe main characteristic of CAPEX is project evaluation analysis, G&G isusually incurred at the beginning of a consider as relevant cost if Companyproject, may be several years before any needs to decide to have G&G to drillrevenue is obtained. The below costs are a well.considered in the CAPEX budget. This cost is considered as part of initial investment if the acreage not a) Acquiring Cost acquired or seismic is not run yet, Acquiring cost paid by Multi- but the historical costs of such companies to obtain a license that activities shall be considered as sunk includes lease bonus; data purchased; costs and excluded in project G&G cost spent for acquiring analysis of drilling well. acreage, legal fees and management or manpower spent for obtaining 7 
  8. 8. c) Exploratory Well e) Facility Cost Exploratory well is a well drilled to The cost of Facility equipments are find and produce oil or gas in an required to produce oil/gas. Some of unproved area. In view of accounting those equipment are required at standards and under successful earlier before production and some method, exploratory well that does later during economic life of well. not find commercial oil or gas, the Facility cost includes tanks, storage, cost of this well is expenses, but if treaters, heater, meter run, commercial oil or gas is found, the separators, flow-line pipes, Vapor cost of this well is capitalized recovery, circulating pump, Injection however, under full cost method, the pump. Those costs are CAPEX. cost of this well is capitalized, Any costs that were incurred before whether oil/gas is found or not. For making a decision of drilling feasibility study of investment or development well shall be project evaluation analysis, considered as sunk cost, and only the exploration cost is considered as estimated costs of drilling relevant cost. development well, facility costs shall Any costs that were incurred before be considered in the cash-flow model making a decisions of drilling exploratory well shall be considered Gross Revenue and Net Cash Flow as sunk cost, and only the estimated In accounting view; Contractor’s gross costs of drilling exploratory well revenue is the Contractor’s portion of oil shall be considered as relevant costs. produced includes the oil cost deducting the expenses The net income of Contractord) Development & Appraisal Well calculated as follow: Development well is well drilled Net Income = Total Sales – Expenses within the proved area of an oil or Where: Total Sales = Total Production – gas reservoir. Appraisal well is a Royalty – Government’s share – Agent Fees well drilled to evaluate the reservoir. Expenses = Operating Expenses – DD&A – The cost of such well is CAPEX. Non-Recoverable Cost In Cash flow Analysis view; Contractor’s Any costs that were incurred before calculate the net cash-flow as follow: making a decision of drilling Net cash-flow = Cash Flow-in – Cash flow- development well shall be out considered as sunk cost, and only the Where: Cash Flow-in = Total Cash Sales estimated costs of drilling Cash Flow-out = Operating Expenses – Non- development well, facility costs shall recoverable cost be considered as relevant cost. 8 
  9. 9. Risk and Risk Management for Foreign stock price, it was found that the CompaniesInvestment that pay more attention to Corporate social responsibilities have lower medium-termStock price risk: return than those Companies that pay lessThe market value of stock are effected by attention to such responsibilities. Means, thevarious factors that will be headlines below, ethical Companies have more financial sacrifice which is accepted by the ethicalthere are factors that directly impact the investors who pay for CSR, there are manymarket valuation of stock and some factors studies enhance the positive correlationhave indirect impact on stock price. between CSR ratings/SDI and stock price such as study that made by Alexis Cellier,Below are some factors that can impact on Pierre Chollet from University Paris forshort-term and long-term investors’ knowing the impact of CSR on Stock Pricesdecisions. based on Vigeo Rating Announcement. 1) Long-run and volatility of ESP Also, there is study made by Haslinda growth rate Yusoff and Glen Lehman from University of 2) Duration of business cycle South Australia for international differences on corporate environmental disclosure 3) Beta risk of the firm practices: a comparison between Malaysia 4) Correlation between the firm’s EPS and Australia, this study enhanced positive and interest rate. correlation between ISO 14001 requirements 5) Dividend payout ratio and EPS and ROE. 6) Liquidity ratio 7) Profitability ratio Therefore, we can confirm there is very little or no relationship between SDI/CSR and 8) Finding cost ratio stock price in short-term, weak relationship 9) Reserve replacement ratio between them in medium-term, good 10) Reserve life ratio relationship in long term. 11) Net wells to gross wells ratio Also, the press release that is announced by 12) Operating cost per well Company or any of kind of media and 13) Present value of cash flow in future related to results of drilling results, potential for reserves oil, financial performance, management performance for managing investors’ moneyThere is indirect factor that can impact on can directly impact the short-term of thethe ethical investors’ or long-term investors’ stock price.decisions which is the Corporate SocialResponsibilities (CSR) or Social Disclosure Uncertain Oil price risk:Index (SDI) such as community Oil and gas prices are subject to high levelsinvolvement, environment, Human of volatility in price and demand. While oilresources, rights and workplace. However, prices rapidly increased and decreased oversome researchers find there is ambiguity of the past years. Decrease oil prices may leadlinks between Corporate Social to close some wells or license that can beResponsibilities or Social Responsibilities non-profitable project. There are manyIndex disclosed in the financial statements factors that can effect oil price that we canand financial performance or capital market list part of them as followperformance, but we can summarize the 1- Scarcity of natural resources (oil)major correlation between CSR/SDI and 2- Strategic Oil stock 9 
  10. 10. 3- Increasing the demand of power interests or harm the national economy by 4- Substitutive commodity reducing prospective leased acreage, 5- No. of wells determined proved Company may face more realistic indirect reserves. expropriation risks that include increasingInsufficiency of funding risk: taxes, compulsory sale produced naturalThe Company may unable to get sufficient resources via government’s control,funds for additional capital to implement progressive labor legislation, or otherand complete its business plans on the lease activities controls that can be initiallyit has interests in which make Company has imposed when Contracts signed withno oil production interests. Therefore, there government or imposed later whencan be absolute assurance given that the Companies start violating contracts orCompany will achieve production from the working in contrast of Soceity’s health,lease. environmental or welfare interests.Political and Security risk: The best way to evaluate the political andThese include the consequences of terrorist, security risks can be quantified withpolitical unsettlement and other activities, expected range. Each political and securitywhich themselves impact adversely on the risk scenario has different degrees ofeconomics of project or investment. uncertainty. Therefore, Company mayExpropriation of assets and terrorism are quantify such risk by estimating thegreatest risks that Oil Industry may face. probability of the each scenario that may happened and the estimated present value ofExpropriation is not easy decision taken by net cash flows to get the Expected Monetarygovernment because it can lead International Value. [Daniel Johnston. community to impose penalties on International Petroleum Fiscal Systems anda government that take such decisions Production Sharing Contracts. PennWellespecially if it is illegal expropriation even if Publishing Company. Tulsa. Oklahoma.U.S.the government compensates foreign Page 136-138 & 145-148]Company. Litigation risk:Expropriation and exercising authority over The Contractor/Operator partner will operateforeign companies is not illegal in the view through a series of contractual relationshipsof international law such as article 1110 of with subcontractors and non-operators. AllNAFTA and UN Resolution 1803, as long as contracts carry risks associated with theit is done in the best interests of the country, performance made by the parties within afor public purpose, non discriminatory basis, time and quality of work performed.foreign company has been compensated atmarket fair value immediately before The Contractor/Operator partner is notexpropriation took place. Therefore, if it is aware of any basis on which any litigationproved that the Company acts illegally that against the Company may arise. However,lead to significantly harm the Country’s there is always the risk that litigation may occur as a result of illegal acts; 10 
  11. 11. unprofessional manner; management following any such unsuccessfuloverriding controls; differing interpretations activity; andof obligations. 3) Increase the probability of relinquishing the lease withoutExploration and drilling and environment recovering the capital investment.risk: 4) Decrease the probability of obtainingOil and gas exploration involves significant new leases in the same Country. If theinherent risks in predicting the location and government of host country promotednature of potential oil accumulations in the and marketed for the already obtainedsubsurface. No Company can give absolute lease that is the one of the best leasesassurance that its exploration investment in the country, and the Company haswill result in the discovery of oil or gas, nor not had any professional drilling andcommercially recoverable. Risks in relation explorative care for this lease, hostto drilling operations or drilling work government will consider the longstructural breakdown may delay for some term economy benefits more thanmonths or few years due to weather or short-term and refuse to provide anyoffshore conditions and shortages of critical new license or extend period ofequipment or materials. current license.Financial and environmental risks: suchrisks include drilling incidents like blow- Discovery risk:outs, fires and oil spills. Those risks can be Any discovery may not be commerciallymitigated by safety and environmental producible. Most of explorationists usepolicies, plans and procedures and will different approach for judging discovery probabilities and chance of success. Thearrange appropriate insurances for particularrisks. No Company can give absolute successful discovery requires the trap to beassurance against the occurrence of any of presented in position indicated bythese or other adverse events. geologists, the target formation must have sufficient thickness, porosity andIn the event that exploration activities prove permeability characteristics must beto be unsuccessful, this will likely lead to: sufficient. The initial/original risk 1) Diminishing the value of any of the assessment or discovery uncertainty is Company’s license subject to such revised based on little information available, unsuccessful exploration activities; therefore, if prospect was drilled and well that may lead to Asset Impairment; was dry it increases the probability of failure and and reducing the probability of success 2) Reduction in the cash reserves of the because drilling wells in the same basin is Company by paying the costs of such dependent events. To mitigate such risk; Oil unsuccessful activities, reducing cash Companies should hire high skilled flow-in that is resulted from sales geologists, and not using very optimistic proceeds of the asset; and, increased factors which increase the discovery difficulty in obtaining additional funds probability and facing dry well after drilling. 11 
  12. 12. Risk Management: international suppliers and foreignRisk Management include risk avoidance, employees.risk mitigation, risk retention, and risk 5) Stop new investment and purchasestransfer, each risk scenario can be managed 6) Reduce any susceptible assets toby one or more of the risk management expropriation or theft risks likemethod depend on the nature, significance, inventories and cashand ability of Company to face the risk. 7) Pay down liabilities to home country suppliersRisk Avoidance: 8) Borrow heavily from local sources.Risk avoidance is going without an [Daniel Johnston. 1994. Internationalopportunity because risk of loss is too high. Petroleum Fiscal Systems and ProductionIf the expected loss is too high that Sharing Contracts. PennWell PublishingCompany cannot take it. The Company Company. Tulsa. Oklahoma.U.S. Page 147-either relinquishes to government or assigns 148]all its working interests to other companiesor refuse to invest in specific acreage. Risk Retention: As it is known that not all risks areRisk Mitigation: avoidable or 100% eliminated, CompanyRisk can be mitigated by reducing loss may establish fund reserves to offset losses.frequency or loss probability. Such as Therefore, Some Companies startenvironment risks which include well establishing provision for meeting anyblowout, harming staff during working probable commitment.period, fires or oil spills, all such risks canbe mitigated by effective Health, Safety, Risk Transfer:Environment, and Security policies and All the risks that can be mitigated, cannot beprocedures that can reduce the probability of 100% eliminated as we mentioned above,occurring such risks. Also, Political unrest but the remaining exposure that cannot berisks can be mitigated by the actions against mitigated to the minimum acceptable levelloss of expropriation and political unrest can be mitigated by spreading risk throughrisks: farm-out, carrying interests, joint ventures and/or insurance, which allow other partiesReducing expropriation risks and losses by: to share the results of the risks instead of 1) Keep low profile investment take it solely. Therefore, discovery risk, 2) Keep very good relationships with sufficiency of funding risks can be spread the government and host country risk through farm-out, carrying interests and community. political risk, environment and safety risks 3) Avoid layoffs and any abusive can be spread through insurance policy. treatments particularly with nationals. 4) Dealing with local suppliers and national personnel more than 12 
  13. 13. Investment Analysis and Cash-flow in the feasibility study of petroleum projects.Models For example, the costs that are associatedMost of Projects of petroleum explorations with already established activities ofare long-term capital investments that goes community affairs in the field that isthrough capital budgeting process for incurred whatever the wells will be drilledmaking long-term investment decision for or seismic acquisition will be run, shall notPetroleum Exploration often grouped in one be accounted for such analysis except for theof the following: incremental costs that could be incurred if the well is drilled or seismic acquisition is ‐ Drilling Development wells in run. Also, acquisition cost of license already productive area for expanding its acquired, and exploration cost of license that business is already explored, are not relevant costs ‐ Running seismic activities and except if those costs will be incurred for drilling exploratory wells for new exploring new prospects or license or licenses. acquire new license. ‐ Acquiring new potential licenses ‐ Optimal production level of oil and To know the variable inputs of cash flow gas and how to be produced. analysis, the contents of the analysis should ‐ Enhancing Oil/gas recovery and be identified first as follow: remediating sites. ‐ Total annual operating costs are ‐ Entering new joint venture daily estimated initial production arrangements or take solely risks. multiplied by 365 days times ‐ Optimal working interest in a estimated operating costs per unit license. and times inflation rate.To take the above decisions, Company shall ‐ For calculating taxes impact, DD&Ahave input variable data for making cash- should be calculated by dividingflow analysis for their long-term investment remaining estimated acquisition cost,decision. The input variable data are tangible development costs byexplained as below. proved reserves times production and facility equipments are depreciatedVariables of Cash-flow Model over their useful life. Intangible costFor estimating expenditures and income to should be amortized based on the taxuse it in the cash flow model, only the law.estimated relevant costs and revenue that ‐ Total revenue is daily initialwill be incurred or avoided in the future production or sales multiplied by 365based on the decision. In other word, the times oil price and times annual priceavoidable, incremental, or differential costs increase per year.and revenue shall be considered in the cashflow analysis. Explorationists may consider After breaking down the contents of costsunavoidable costs or non-incremental costs and revenue to cost and revenue drivers, the 13 
  14. 14. variable input could be easily determined as The estimated initial average dailyfollow: production shall be estimated at bbls/day from number of wellInitial Production ForecastVarious countries such as U.S issue Oil Price and price escalationregulations or have concession agreement Crude oil that is produced from differentindicating to well spacing limitations, sources are categorized mainly according toutilization of reservoir, and allowable its API gravity and sulfur content. The APImaximum production limits, all of those gravity of light crude oils are over 40, heavyeffect the estimated production. Also, some oils are below 25. The average crude oilsPSAs such as Kurdistan and Libyan require have 25 to 40 range. The price of crude oil isto produce rate not exceeding Maximum dependent on API gravity and sulfurEfficient Rate (MER) which can effect content, sweet crude oil contains less thanreservoir pressure that lead to excessive 0.5% by weight and sour crude oil containsdecline of production. more than 1.5% by weight. The higher API gravity, the lighter oil is, the higher priceThe initial production per well can be receives and vice versa, and the lower sulfurestimated by the nearest productive well contents in oil, the sweeter it is, the higherdrilled that be expected to have the same value of oil and vice versa.wellbore pressure and target productiveformation, or obtaining the average Many PSAs recommend calculating the oilproduction of the nearest wells. cost based on the international or world oil price market based on FOB. EvenDiscovery probability, Net present value of Contractor sells their portion of oil producedsuccessful well, average cost of exploratory based on international market such as Brentdry hole, Capital investment source that is traded in London and West Texasavailable, and reasonable confident Intermediate (WTI) that is traded in Newprobability are factors that determine the York Mercantile Exchange NYMEX ornumber of well Company may need to drill. Dubai Market.Declined production can be considered in [Morgan Downey. 2009. OIL 101. Woodenthe analysis if the Company needs to drill in Table Press LLC. Page 34-36]the same reservoir and cannot be consideredin the analysis if Company drill the first well The oil price shall be estimated at $ perin new reservoir because to specify the barrel Also, as we noticed recent years thatdecline rate, the quantity produced in t+1 or oil price has been rapidly increased,t time shall be known, and it cannot be therefore, price escalation should beknown until the production run. Therefore, considered and estimated by percentage perthe estimated initial production for well or year.all wells is constant over the economic lifeof the prospect. 14 
  15. 15. Agent/Sponsor Fees Drilling wells in the same basin is dependentCompany intends to investment in oil & gas events which need to revise or update theindustry in Middle East, should have local discovery probability that was previoussponsor, and have sponsor agreement which calculated for the license or for the nextstated that Contractor’s should pay drilling well, but it will be independentpercentage of contractor’s profit oil to the event if they are drilled in different basin.sponsor [Daniel Johnston. 1994. InternationalReserves Petroleum Fiscal Systems and ProductionReserves in barrels are disclosed in the Sharing Contracts. PennWell Publishingfinancial statements, and it is a factor for Company. Tulsa. Oklahoma.U.S. Page 339-calculating DD&A of CAPEX expenditure 342 & 357]as it is mentioned in above. The discovery probability shall be estimatedGeologists calculate the expected by by explorationists in percentage.recoverable reserves based on many factorswater saturation, net pay thickness, porosity, Expenditure Forecastand others. For estimating expenditures to use it in the cash flow model, only the estimated relevantThe larger expected recoverable reserves in costs that will be incurred or avoided in thethe field, the more field could be attractive future as we indicated above.and feasible, and the higher pressure in thereservoir the more recoverable reserves can a) Expected Drilling Wellbe produced in short term. The expected Preparation of drilling cost estimaterecoverable reserves of any prospect shall be is depend on type of wells, theestimated by number of barrels that can be drilling cost is high;recovered and provided by technical staff. 1) For exploration and appraisal wells generally cost moreDiscovery probability (Chance of success) 2) If the well drilled horizontal orCalculation of discovery probability is made Explorationists or Geologists that can be 3) If the well is drilled at offshoreimpacted on the following factors as rig costsexamples: 4) If the well is more deep and ‐ Probability of reserves trap formation is more complicated. ‐ Probability of source 5) If well is drilled in high ‐ Probability of mitigation pressure, or through sloughing ‐ Probability of time shale. ‐ Probability of net pay thickness Estimating drilling a well will be one ‐ Probability of reservoir porosity of the following method: ‐ Probability of reservoir permeability 1) Obtain the average cost / meter depth for nearest well drilled, assuming the complexity and 15 
  16. 16. pressure of drilled and cost to project evaluation analysis for undrilled reservoir are almost drilling a well, but we consider lease the same. acquisition costs can be estimated by 2) Obtain the average cost per the actual costs paid by other meter depth for a well in Company investing in the same anywhere in the basin with country or by providing the considering the pressure; and preliminary negotiated prices.. complexity of formation. 3) Making Work Structure c) Expected G&G Cost Breakdown for drilling a well G&G cost includes; a) Seismic and estimate the cost for each acquisition cost that is estimated activity. And this method is based on the average cost of more accurate but consumed acquiring seismic survey per square more time and cost to be kilometer if it is 2D or cubic prepared. kilometer if it is 3D, or per shots or lines, this cost is the highest cost in The average drilling cost can be G&G which covers the costs of estimated either by per well or per manpower and equipments such as meter depth. Many Countries have vibrators, dynamites and others; b) statistics for well costs which show Seismic Processing/Reprocessing the costs per meter drilled and per and Interpreting; this costs may be well and by drilling service done inside the company or outside company, such statistics can provide the Company based on the us with estimated cost for well to be experienced team and high drilled in future but in consideration technology is used; those costs are of inflation rate for the cost per year. estimated based on average cost of processing/ reprocessing/b) Expected Lease Acquisition Cost interpreting data per square or cubic As it was mentioned above that kilometer or per hours spent by Lease acquisition cost paid by expatriates for such work; c) Contractors to obtain a license that geological studies and geochemical includes lease bonus; data purchased; studies this is estimated based on the G&G cost spent for acquiring cost of service is offered such as acreage, legal fees and management geological formation analysis. G&G or manpower spent for obtaining costs before finding commercial oil such lease before signing the or gas are considered cash flow-out. Production-sharing contract with government. Acquisition costs is In the whole world, the average cost considered as Initial Investment for of seismic acquisition is about $ feasibility studies of obtaining 2000-8000 per kilometer of 2D acreage, and it is considered as sunk seismic data; and $.15,000 - $20,000. 16 
  17. 17. Squ. kilometer of 3D seismic data are considered as billable costs with vibrator. which are carried by partners which is offset with PSA overhead. Thed) Expected Facility Cost annual estimated overhead can be Facility cost shall be estimated based computed based on provision of on the assets needs and activities performed. Facilities equipments PSAs or JOAs cover various items such as tanks, g) Inflation Rate pipelines, separator, heater, splitter. There is positive correlation betweene) Operating Cost oil price and general inflation rate Expected operating cost is calculated and operating cost escalation. by barrel. The operating cost per Therefore, the higher oil price is, the barrel can be obtained by higher inflation rate is and cost of oil equipment. In cash-flow analysis, it a) taking the latest historical is assumed about general anticipated operating costs and production level of inflation rate and if this from the other Companies inflationary expectation is embedded operated in the same country that in cash-flow analysis, the net cash is produced from the same target flow will be called nominal net cash formation, flow. The annual inflation rate is b) statistics issued by official estimated in percentage and can be governmental of host country, constant during the analysis period. c) from latest historical operating costs of consolidated financial Cost Recovery Ceiling information of a company Cost recovery ceiling is provided by PSA divided by total equivalent that make a limit for recovering costs and production in BOE from home any cost recovery excess the limit should be office financial statements or forwarded to next period. The cost recovery d) based on estimated cost of ceiling is varied between PSAs. planned production activities which is more accurate but Contractor’s working Interest consumed more time and cost to Contractor’s working interest is varied from be prepared. from company to another.f) Non-Recoverable by government Many PSAs indicates to Company’s and partners working interest of revenue that is different Non-recoverable costs from oil costs from paying interests. Paying Interests are and from non-operators are higher than revenue interests due to foreign considered solely carried by multi-companies carry the interests of public operators which is offset with corporation of host government. operator’s overhead, and non- recoverable costs from only oil cost 17 
  18. 18. Taxation Cost of site remediation andIncome tax is accounted for DD&A which is abandonmentconsidered as sunk cost, put taxes should be Cost of abandonment should be anticipateddeducted from cash-flow. to meet contractual obligations and usually before production began by performing a) Host Country Tax Rate Environmental Impact Analysis (EIA) based PSAs in Middle East countries on either PSAs (e.g. PSC of Kurdistan) and exempt International Oil Companies local environmental regulations or from taxes but PSA of Yemen constructive obligations based on require International Oil Companies Company’s policy and practices. to pay some taxes that are not recoverable such as fixed tax. Such cost could be recovered should be charge the Joint Venture and Petroleum b) Corporate Tax Rate accounts during the last period of productive Corporate tax rate is varied from license in some PSAs. This cost could be country to another. Corporate tax categorized under disposal cash flow but if it rate shall be determined in scale rate is 100% recovered when it is incurred, it based on the law. will be nil and not be included in the cash c) Production Tax Rate flow model. There is no production tax law is Proceeds of selling license. prevailed in some Middle East Company’s may decided to sell its working countries, but Volware or exercise interests to other Companies either license is tax is imposed by some resident productive, development or exploration country of company. And foreign license after period of time. The estimated production may not imposed on such proceeds of selling the license shall be taxes considered in disposal cash flow.Bank charges on LOC For estimating the proceeds of sold licenses,Bank charges on Letter of Credit or we need to make cash flow analysis andGuarantee LOC/LG is non-recoverable cost estimate the present value of net cash flowas per some PSAs, but it is compensated by for reserves after period of time forpartners if it is accounted based on gross productive or development licenses only andLOC not on partner’s portion of LOC. it will be high roughly estimation. Cash-Financing cost is deducted from cash flow. flow Model is useful for production andThe amount of LOC should be the same development licenses but for estimating thevalue of the minimum work obligation. proceeds of exploration license the cash-Bank charges rate shall be provided by flow model is not appropriate, the costfinance team. approach will be appropriate for estimating the value of exploration license in future. However, the proceeds will be high roughly estimated. 18 
  19. 19. In summary, Cash-Flow Model contains cash flow out and should not be discounted,three types of cash flow: figure 2 of operation cash flow which most likely represents net cash flow in that needs a) Incremental Cash flow of initial to be discounted over the period of cash investments flow in entity and figure 3 of disposal cash b) Incremental Cash flow of operation flow that represents either cash flow in or c) Incremental cash flow of diposal out and need to be discounted at the end ofThose incremental cash flow have been the period.summarized in the below figures. Figure 1of initial cash flow which represents netFigure 1: Initial Cash Flow*- Acquisition cost- Exploration Cost (include G&G and exploratory drilling wells, regardless of recoverabilityconcept)- Development Cost (Include Development wells cost and facility cost)= Initial Cash FlowFigure 2: Operation Cash flows*+ Production Income [(Company’s share of profit oil + Cost Oil) X Oil Price x Price Escalation%]+ Credits against expense [ Overhead Compensated by other partners allowed by JOA]- Royalties payments- Ad volarem, production or sale Tax [Produced or sold quantifies X tax scale rate]- Operating Cost- Corporate Overhead- or + DD&A, Non Cash Outflows= Net Cash flow Before tax- or + Tax effect (Taxes or savings)+ or - DD&A, Non Cash Outflows= Net Operation Cash flowsFigure 3: Disposal Cash Flows*+ Estimated proceeds of selling Company’s working interests in a license.- Cost of Disposed license [Remaining of non-depleted cost + non-recovered environmentalLiability]= Net Cash flow Before tax- or + Net Tax impact (taxes or savings) 19 
  20. 20. + Cost of Disposed license [Remaining of non-depleted cost]= Cash flow at disposal*The above figures have been excerpt from 2007 CMA Learning System: StrategicManagement. Part 3. Version 2.0. IMA. Page 354-355Discount rate and WACC Expected Utility Value (EUV)The value of money is depreciated over EUV is the NPV which is converted intotime, therefore, for cash flow model and utility value using mathematical functioninvestment analysis, the present value shall which risk tolerance and net present valuebe computed at required rate of return as are the main variables in the rate, some companies preferred touse discount rates that equal to their Risk tolerance is the risk valued in dollarweighted average cost of capital (WACC) or which show how much the value of risk thatfree-risk rate plus risk premium. Discount Company can carry. The larger value of riskrate shall be provided by finance team. tolerance, the more indication of Company is risk-seeker and like to take more risks. Risk tolerance can be used for determiningDecision Analysis the joint venture working interests thatIn decision analysis or project analysis, we optimizes its participation in Joint venture.need to use capital budget techniques andother techniques that apply the following. Company should select the project or license that miximizes the expected utility value.Net Present Value (NPV) [Paul Newendorp, John Schuyler. 2000. 2ndNet present value is annual cash flowin edition. Decision Analysis for Petroleumtimes present value at discount rate Exploration. Planning Press. Aurora.deducting the initial investment amount. The Colorado. USA. Page 159-219]positive and high NPV is, the moreattractive investment or project is. Payback Period Payback period is the breakeven point or theExpected Money Value (EMV) period of time that a company will recoverEMV is the NPV times the discovery its initial investment cost. A corporate mayprobability or Chance of success in specific has a policy that determine the acceptedprospect. The higher EMV, the more payback period of any new investment inattractive investment or project is. Company select the project or license thathave the greatest EMV if the risk in neutral Internal Rate of Return (IRR)between the alternatives. But if the decision IRR is a measure of profitability that reportmaker is risk-seeker or averse, the risks the percentage of net cash flow to the initialshould be considered in the preference investment. This ratio accounts for timemodel. Therefore, Utility function should be value of money and cannot be useful if theconsidered for evaluating among projects. all or cumulative cash flows are negative. 20 
  21. 21. The investment or project that its IRR that is Capital Investment Fund Requiredgreater than return on alternative use of Fund required for capital investment offunds, required return or WACC, is reservoir is very important because theacceptable investment, otherwise it is project might be very attractive but it will bereferred to be rejected. This technique shall beyond the ability of the company to operatebe read with NPV and PI index. and even to take the investment.Accounting Rate of Return (ARR) or Breakeven/ Cost-Volume-Profit AnalysisAverage Return on Investment Breakeven analysis could not be easy forThis technique calculates rate of the average management accountant because it dependsannual income to initial investment that on identifying the variable cost from fixedignores the time value of money. This ratio costs. However, operating costs area easilymay not be as useful as other techniques but to be classified between direct and indirectsome companies like to calculate this ration costs, but discovery and production costto know how much this investment or could be fallen into variable and fixed costproject will contribute in aggregate net in somehow. Discovery and productionincome to assets. fixed costs that are not changed in correspondence with changes in quantitiesProfitability Index (PI) of oil and gas produced. Therefore, fixedPI helps a company to know present value costs could be the DD&A of acquisition,generated per dollar of investment, it is very development and facility cost or the full ofuseful because it considers the time value of such cost, cumulative exploration cost canmoney and size of the project. It is useful if be considered in addition to full cost ofCompany needs to select several acreage or acquisition and development as fixed costsdrilling well investment that have different to determine the non-profit production thatNPV and initial investments. The higher PI cover discovery and production cost and tois the more attractive the investment or determine the target profit from theproject will be. And PI that is less than 1 production or development license. Variablewill be rejected. cost is changed with quantities of oil/gasFinding Cost. produced, variable costs are such adThis ratio is used to evaluate the efficiency volerum or severance taxes, royalties, costof a company in adding new reserves, it of daily well operation activities.helps a company to know how muchcompany carry dollars to find a barrel ofproved reserves. This ratio can be revised todiscounted costs, where, the finding costs isdivided by discounted reserves thatproduced annually, if the discounted findingcost is greater than the estimated oil price,the project will not be attractive to enter todevelopment or production phase. 21 
  22. 22. Comprehensive ExampleThe below data are variable input data that could be used in Cash-flow model. We will assumed that we have four licenses, onelincense is under exploration that a Company had three prospects to be drilled, two licenses are under study to acquire one of them orneither, one license is in development phase and another license is production license.The below cash flow model is simply prepared to provide our readers an overall idea of how to make investment or decision analysisfor petroleum exploration in brief: ‐ If we want to choose either to acquire license F or E, the below analysis can provide how much present value and expected monetary value are in both license, and IRR, payback, finding cost and breakeven point in daily produced bbl. Company may choose license E as long as it has not enough fund or its risk tolerance is small. ‐ Company has three prospects to be drilled in exploration license. Prospect C is not attractive because its net present value is negative, Prospect B is not attractive, however, its present value is in positive and it is about $9mm but the expected monetary value of prospect B is negative and its expected profitability index is less than 1. It its feasible for the company to drill a well in Prospect A, however, its probability of discovery is 7%, but its net present value and monetary value is positive, and all 22 
  23. 23. other indices such as IRR, PI, Finding cost, Breakeven points in daily bbl, and payback period encourage company to invest and drill a well in prospect APlease see next page that show the table of investment and decision analysis that is simply prepared. Cash-flow and decisionanalysis could be prepared in more complicated form that show the annual cash flow in separate column and compute the netreserves, net production, escalated oil prices and increased operation costs and tax more accurately based on tax laws, PSAs,JOAs. 23 
  24. 24. References ‐ Production Sharing Contract with Yemen Government. ‐ Model Production Sharing Contract For Exploration And Production In Kurdistan. Available at: %20Sharing%20Contract.pdf ‐ Model of Exploration And Production Sharing Agreement between National Oil Corporation established in Libya and other. Available at: Agreement,%20Oil%20&%20Gas.pdf ‐ Model Production Sharing Contract for Petroleum Exploration and Production in Turkmenistan (Part 1). Available at: &source=web&cd=2&cad=rja&ved=0CDEQFjAB& %2Fdocs%2Ftexts%2Ftuk81989E.doc&ei=RYLAUPa1LYfzsgaZl4HACQ&usg=AFQjC NEgd2QW1dw38u3qvnU6_qP8sHOL-Q ‐ JOA of 3 Parties participated in Yemen. ‐ JOA between 2 parties participated in Yemen ‐ IRS Oil and Gas Handbook. Available At: 001.html ‐ U.S Treasury Regulations. Available At: ‐ Australian Taxation: ‐ Daniel Johnston. 1994. International Petroleum Fiscal Systems and Production Sharing Contracts. PennWell Publishing Company. Tulsa. Oklahoma.U.S ‐ Paul Newendorp, John Schuyler. 2000. 2nd edition. Decision Analysis for Petroleum Exploration. Planning Press. Aurora. Colorado. USA ‐ Alexis Cellier, Pierre Chollet. April 30, 2010. The Impact of Corporate Social Responsibility on Stock Prices: An Event Study of Vigeo Rating Announcement. Université Paris-Est, Institut de Recherche en Gestion. France. Available at: ‐ Morgan Downey. 2009. OIL 101. Wooden Table Press LLC 24