Knowing When to Quit: Timing Petroleum Field Abandonment Decisions to Optimize Net Present Value

Knowing When to Quit: Timing Petroleum Field Abandonment Decisions to Optimize Net Present Value
Knowing When to Quit: Timing Petroleum Field Abandonment Decisions to Optimize Net Present Value
Introducing an alternative economic limit test to maximize investor net present value.
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Summary:

Presented is a simple, transparent and mathematically sound approach to calculating the ELT (economic limit test) by considering all actual investor cash inflows and outflows (including abandonment costs) and the time value of money. This method - in contrast to common industry practice, including PRMS guidelines promulgated by the SPE et.al --permits (to the extent that any forecast model can) timing the abandonment decision to maximize investor NPV (Net Present Value).

If the aim of investment activity is to maximize value to the Investor, then the time to end the activity is when the Investor believes maximum possible value is achieved, before value is destroyed by continuing. To prevent such value destruction, upstream petroleum industry investments usually have some form of economic limit test (ELT) which determines that it is time to stop a project when forecasted “value” (i.e. some definition of revenue minus some definition of costs) would otherwise turn permanently negative.

While this is appropriate, the authors believe that industry participants commonly use ELTs which are flawed, because they are based on the wrong measure of value. Although the industry does generally agree that the point of investment is to maximize value, specifically post-tax Net Present Value (NPV) of future Net Cash flow (NCF) – i.e., all revenue received by the Investor, less all costs incurred by the Investor, discounted using an appropriate discount rate – in practice, commonly used ELT calculations erroneously measure something else.

Scope:

This report presents – both in the article and in several Microsoft Excel models -- a simple, transparent and mathematically sound approach to calculating the Economic Test Limit (ELT) in a way calibrated to maximize Investor Net Present Value (NPV). It does so with comparative, parallel calculations based on what the authors believe to be the common, but flawed industry approach, which ends up maximizing not Investor NPV, but rather a variant of cashflow which is less meaningful, as it excludes certain Investor costs.

One such set of excluded costs are abandonment costs, which, using the common industry approach, can be difficult to include in the ELT calculation as it can lead to mathematical circularities. Other such excluded costs include income taxes, the time value of money, and in some cases, revenue “lost” to governments under Production Sharing Contracts (PSCs). The authors contend that since Investors do in fact consider all these items when calculating NPV, then they should also consider them calculating the ELT, and thus when to schedule abandonment. In other words, if maximizing Investor NPV is the point of investing, then both the valuation and ELT calculations should focus on the same thing.

The article and models show how to base the ELT on NPV maximization while avoiding circular calculations, and provide several fiscally detailed and plausible models showing how the authors’ approach can result in materially higher NPV than the common industry approach. Included are:

  • Discussion and illustration of the common industry approaches to ELT calculation, including the variant prescribed by PRMS guidelines
  • A detailed analysis of the flaws of these approaches, e.g. the failure to account for Investor NPV determinants such as income taxes, abandonment costs, and the actual revenue received by investors under PSCs
  • A simple Excel model and discussion illustrating the authors’ NPV-maximizing ELT calculation method
  • Four more detailed Excel models, based on actual fields and fiscal regimes, which apply both the flawed industry approach to ELT and the authors’ own approach, showing how the latter can lead to abandonment decisions which materially enhance Investor NPV
  • Of these detailed models, two are based on Tax & Royalty regimes, and two on PSC regimes
  • For each fiscal regime type modelled, two common abandonment funding methods are examined
  • Detailed analyses of each model’s results, highlighting what the flawed, common approach “misses” and what the authors’ approaches “considers”
  • Reasons to Buy:

    • Gain knowledge of the conventional formula for determining petroleum field abandonment
    • Learn a simple and transparent alternative method for including abandonment costs, income taxes, the time value of money and other NPV-relevant factors when calculating ELT
    • Review case studies and analysis using both approaches

    Publication Date:

    January, 2012

    About Authors:

    Ken Kasriel is a Senior Petroleum Economist with RPS Energy, London. He has 17 years experience in petroleum finance. His past employment includes Creditanstalt Investment Bank, Robert Flemings Securities, and PriceWaterhouseCoopers.


    David Wood - Oil & Gas Journal author, and principal consultant of DWA Energy Limited, UK, specializing in the integration of technical, economics, fiscal, risk and strategic information to aid portfolio evaluation and project management decisions. He has more than 30 years of international oil and gas experience and has been employed by Philips Petroleum, Amoco and Canadian independents.