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Basic Economic Principles
Dr. Alfred KjemperudThe Bridge Group AS
Dr. A. Kjemperud 2CCOP, Pattaya, September 2003
Petroleum Investments
• Petroleum Investments are:capital intensive irreversible risky
• Economic analysis and modeling is a method to reduce the risk when taking decisions
• Discounted cash flow modeling is based on basic economic principles
Dr. A. Kjemperud 3CCOP, Pattaya, September 2003
Economic Modeling
• Main elements in a discounted cashflow model:
CashflowNet Present ValueInternal rate of ReturnOther decision criteria
Expected Monetary ValueMaximum Sustainable riskPay back timeNumber of return of investmentsBreak even oil price
Dr. A. Kjemperud 4CCOP, Pattaya, September 2003
Cash flow – one year
Income- costs= Net cash flow
Dr. A. Kjemperud 5CCOP, Pattaya, September 2003
Cash flow every year
Income- costs
= Net cashflow
Year
Income- costs
= Net cashflow
Income- costs
= Net cashflow
0 1 2 time
Dr. A. Kjemperud 6CCOP, Pattaya, September 2003
The real world[Million USD] SUM Revenue from oil+as.gas 28426.5Revenue from gas+cond. 0Gross project revenue 28426.5 Royalty [million usd] 7031.6 Royalty % 24.7 %Net Project Revenue 21394.9Cost recovery 0.0Total capex 977.4 - Depreciations 977.4 - Expensed opex 2252.9Total costs 3230.3Total unrecov. costTotal cost cum.Cost recovery limit 21394.9Total costs recovered 3230.3Total costs recovered cum.Profit basis (op. Income) 18164.6State profit 1083.6State profit % 6.0 %Contractor profit 17081.0Contractor profit [%] 94.0 %Contractor revenue 20311.3Contractor revenue 20311.3 Total CAPEX 977.4 Total OPEX 2252.9Net cashflow before inc. tax 17081.0 Total income taxes 5124.3Net cashflow after tax 11956.7
Income
Cost
Net Cash flow
Dr. A. Kjemperud 7CCOP, Pattaya, September 2003
OutflowOutflow
-600
-400
-200
0
200
400
600
800
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Mill
ion
USD
Outflow
Dr. A. Kjemperud 8CCOP, Pattaya, September 2003
Inflow
-400
-200
0
200
400
600
800
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Mill
ion
USD
InflowOutflow
Dr. A. Kjemperud 9CCOP, Pattaya, September 2003
Cash Flow
-400
-200
0
200
400
600
800
2003
2005
2007
2009
2011
2013
2015
2017
2019
2021
2023
2025
2027
2029
Mill
ion
USD
InflowOutflowcash flow
Dr. A. Kjemperud 10CCOP, Pattaya, September 2003
Cumulative Cash flow
-500
0
500
1000
1500
2000
2500
3000
3500
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Mill
ion
USD
Cash flow
Cummulative cashflow
Dr. A. Kjemperud 11CCOP, Pattaya, September 2003
Cash Flow over time
• We can’t just add up inflow and outflow. This is due to:
InflationTime Value of MoneyUncertainty
Dr. A. Kjemperud 12CCOP, Pattaya, September 2003
Inflation
• As long as there is inflation thevalue of 1$ today is more than 1$ in the future.
• One could buy more for 10$ in 1980 than in 2003 - and probably more in 2003 than in 2010
• Inflation is adjusted for by using real values instead of current values
Dr. A. Kjemperud 13CCOP, Pattaya, September 2003
Inflation corrected
-500
0
500
1000
1500
2000
2500
3000
3500
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Mill
ion
USD
Cash flow
Cummulative cashflow
Inflation corrected
Current Values
Real Values
Dr. A. Kjemperud 14CCOP, Pattaya, September 2003
Present Value
• Future in- and out-flow must be discounted to be comparable.
• Net present value of a project is the sum of discounted cash-flow elements.
• Discount rate should be the rate of return of the best alternative use of money
Dr. A. Kjemperud 15CCOP, Pattaya, September 2003
Time value of money
• Alternative investmentsBank - small riskFonds - higher riskOther projects- high risk
Dr. A. Kjemperud 16CCOP, Pattaya, September 2003
Future Value
• F = P(1+i)n
Example$1000 invested at 10% for five years:
F = $1000(1+0.10)5 = $1,611
F = future valueP = Present value (principal)i = Interest raten = Number of time periods
Dr. A. Kjemperud 17CCOP, Pattaya, September 2003
Present Value• P = F/(1+i)n
• Example
After 5 years at 10 % interest in the bank you are paid back $1000. What was the principal?
P= $1000/(1+0.10)5
P= $1000/1.6105
P= $ 621
F = future valueP = Present value (principal)i = Interest raten = Number of time periods
Dr. A. Kjemperud 18CCOP, Pattaya, September 2003
NPV formula (end year)
...where:Vt - the net income in year t i - discount rate N - total numbers of years (project duration)
P1
(1 + i)1P2
(1 + i)2PN
(1 + i)N= + + ... +P0 +
Pn
(1 + i)n( )∑n = 0
N
NPV =
Dr. A. Kjemperud 19CCOP, Pattaya, September 2003
Time value of money
-500
0
500
1000
1500
2000
2500
3000
3500
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Mill
ion
USD
Cash flow
Cummulative cashflow
Inflation corrected
+ Value of time corrected
Current Values
Real Values
Discounted Values
Dr. A. Kjemperud 20CCOP, Pattaya, September 2003
Risk premium
• Petroleum projects always possess a certain risk of failure
• The risk vary due to a multitude of factors (geological, technical, political
economical)
• A risk premium is often added to the discount factor
Dr. A. Kjemperud 21CCOP, Pattaya, September 2003
Discounting incl. risk premium
-500
0
500
1000
1500
2000
2500
3000
3500
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Mill
ion
USD
Cash flow
Cummulative cashflow
Inflation corrected
+ Value of time corrected
++ Risk corrected
Current Values (0%)
Real Values (3%)
Discounted Values (7%)
Risk corrected Discounted Values (5%)
Dr. A. Kjemperud 22CCOP, Pattaya, September 2003
NPV formula (mid year)
...where:Vt - the net income in year t i - discount rate N - total numbers of years (project duration)
P1
(1 + i)(1-0.5)
P2
(1 + i)(2-0.5)
PN
(1 + i)(N-0.5)= + + ...... +P0 +
Pn
(1 + i)(n-0.5)( )∑n = 0
N
NPV =
Dr. A. Kjemperud 23CCOP, Pattaya, September 2003
Discounting
707
758
-500
0
500
1000
1500
2000
2500
3000
3500
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Mill
ion
USD
Cash flow
Cummulative cashflow
Inflation corrected
+ Value of time corrected
++ Risk corrected end year
++ Risk corrected mid year
Dr. A. Kjemperud 24CCOP, Pattaya, September 2003
Net Present Value1 Calculate separately
the present value of all the cash-flow elements
2 Add together the discounted cash-flow elements
Time 0 1 2Cash-flow -100 80 70
Present value:-100
7562
-100 + 75 + 62 = 37
80/(1.06)
The net present value of the cash-flow of the project is 3770/(1.06)2
interest rate is 6%
Dr. A. Kjemperud 25CCOP, Pattaya, September 2003
Present Value
Year Cash Flow NPV 5% NPV 10% NPV 15% NPV 20%2003 -200 -200.0 -200.0 -200.0 -200.02004 -50 -47.6 -45.5 -43.5 -41.72005 10 9.1 8.3 7.6 6.92006 100 86.4 75.1 65.8 57.92007 100 82.3 68.3 57.2 48.22008 200 156.7 124.2 99.4 80.4
SUM 160 86.8 30.4 -13.6 -48.3
Dr. A. Kjemperud 26CCOP, Pattaya, September 2003
Present Value - IRR
-100
-50
0
50
100
150
200
0 5 % 10 % 15 % 20 %
Discount Factor
NPV
IRR
Dr. A. Kjemperud 27CCOP, Pattaya, September 2003
Economic Decision Criteria
• The discount rate that yields NPV=0 defines the Internal Rate of Return (IRR)
A simple decision criteria would be:
Accept all project with IRR > discount factor
Drop all project with IRR < discount factor
Dr. A. Kjemperud 28CCOP, Pattaya, September 2003
ExerciseNet Present value - IRR
•Use the cash flow given in the table to the right as basis for calculating NPV at 0,5,10,15 and 20 % discount rate. Use the result to find the approximate Internal Rate of Return (IRR).•If you have time use both end year and mid year discounting
Year Cash Flow•2003 -300•2004 -100•2005 10•2006 100•2007 200•2008 300
Dr. A. Kjemperud 29CCOP, Pattaya, September 2003
Present Value
-300SUM
3002008
2002007
1002006
102005
-1002004
-3002003
NPV 20%NPV 15%NPV 10%NPV 5%Cash FlowYear
Dr. A. Kjemperud 30CCOP, Pattaya, September 2003
Discounted Cash Flow
-101.5-50.115.499.8210SUM
120.6149.2186.3235.13002008596.5114.4136.6164.52002007457.965.875.186.4100200636.97.68.39.11020052
-83.3-87.0-90.9-95.2-10020041-300.0-300.0-300.0-300.0-30020030
NPV 20%
NPV 15%
NPV 10%
NPV 5%
Cash FlowYear
Dr. A. Kjemperud 31CCOP, Pattaya, September 2003
IRR
-150
-100
-50
0
50
100
150
200
250
0 5 % 10 % 15 % 20 %
Discount Factor
NPV
IRR = ~11.5%