Measures of Investment Size

In many investment situations, it is desirable to be able to determine the “size” of the

financial commitment to a project.

Size is important, when a measure of investment efficiency, ie “profit generated, per unit
of currency invested”, is required.

There are two, commonly used measures of investment size, namely capital
Project expenditure or “Capex” and Maximum Capital Outlay or “MCO”

Parameters
Maximum Capital Outlay, or MCO is defined as the minimum value on the cumulative NCF
curve.

In Figure 67, Foinaven cumulative NCF is plotted and the minimum point [-763] in 1997 is
labelled. This is the MCO for the project.
 Measures of Investment Size

Project
Parameters
 Payback Period
Payback incorporates the idea of recovering one’s investment.

In its simplest form, it is the point at which the cumulative NCF returns to zero.

The Payback “Period” is defined as the time taken, from the start of the project, to reach this
position.

Data for Foinaven are plotted in Figure 66.

Project This indicates the cumulative NCF curve crossing the axis between 2000 and 2001, suggesting a Payback
Parameters near the end of 2000.

Assuming a project start around the beginning of 1994, this indicates a Payback Period of about 6 years.
It is to be expected that larger, more complex projects have longer Payback Periods.

Figure 69 is based on cash flows for three contrasting UK projects.

Brent is very large with MCO of about £6200 million,
Foinaven is medium sized, with MCO of about £750 million
and Arbroath is small with MCO less than £200 million.
Indicated Payback periods are 9-10 years, 7-8 years and 4-5 years respectively.
 Project
Parameters
 Project
Parameters
 Terminal Cash Surplus

The simplest measure of a profit relates to the concept of a surplus.

If I spend £X and earn £Y, I have made a profit of £[Y-X].

In the context of project NCF, the cumulative value at the end of the project’s life is such a
surplus.

It is the sum of all project Revenues, minus the sum of all Capex, Opex and Taxes.

Project This sum is variously called Net Cash, Terminal Cash Surplus, or Terminal Value of the
Parameters project.

Larger projects tend to have larger cash flows and larger cash surpluses.

In Figure 69, Brent, the largest project has a TCS in excess of £6500 million,

Foinaven, the intermediate project has a TCS of almost £1500 million

and Arbroath, the small project has a TCS of £700 million.

It is important to note that TCS is in the same units as the cash flows and NCF from which it
is derived.
 Profit to Investment Ratio
The Profit to Investment Ratio is a measure of investment efficiency, incorporating the idea of
optimising profit earned for every pound invested.

This is likely to be important in a situation, where investment pounds or dollars are limited.

The simplest measure of efficiency is the ratio between TCS, as a measure of profit and MCO, as
a measure of investment.

These data are derived directly from the cumulative NCF and the resultant ratio is popularly known
as Profit to Investment Ratio [PIR].
Project
Parameters The calculation of PIR from cumulative NCF data is entirely
straightforward, as shown in Table 38.

A PIR of 1.915 for the Foinaven project indicates that there will be,
eventually, a cash surplus of £1.915 for every pound invested.
 Project
Parameters
 Net Present Value

Project
Parameters
 Project
Parameters
 Data is derived from the Foinaven Field.

For each project year, NCF is listed in £2000 terms.

The time origin for discounting is 1994, the first year of significant
expenditure.

Project Therefore, in 1994, n = 0.

Parameters Discounting is performed at 10% per annum.

Therefore, discount factors [DF] are based on [1.10] -n

A Present Value is derived from NCF for each project year.

Present Value [PV] and discounted cash flow [DCF] are

equivalent terms.
 Internal Rate of Return

The Internal Rate of Return [IRR] is the discount rate, which reduces the project NPV to zero. It
is, therefore, the solution to the following equation:

Project
Parameters
 Cumulative Cash Flow against Time
1000.00 TCS

800.00

600.00

400.00
Project

CCF (£ million)
Parameters 200.00

0.00
0 2 4 6 8 10 12 14 16 18
-200.00

-400.00

-600.00

-800.00
MCO

Time (years)
 Decommissioning tax rules

Project
Parameters
 Why increasing discount/compound rate results in decreasing
NPV?

Project
Parameters
 Internal Rate of Return

The Internal Rate of Return [IRR] is the discount rate, which reduces the project NPV to zero. It
is, therefore, the solution to the following equation:

Project
Parameters
 Abandonment Expenditure and Sinking Funds
Many projects incur significant expenditure relating to decommissioning, site clearance
etc.
A necessary assumption here is that any such expenditure is a legal obligation on the
project and must be paid for out of project revenues.

The idea is that project revenues must first provide for abandonment and that whatever
remains may then be considered as return on investment.

Project A secondary issue relates to the appropriate time value of money to apply to the “provision
Parameters for abandonment” phase.

The standard IRR calculation, uses a constant discount rate for all project periods and
consequently, there is the implicit assumption that the “provision for abandonment” is
invested at this same rate i.e. the rate indicated by calculated IRR.

Note that the same interpretation applies to any discounted cash flow analysis, which
applies a constant discount rate throughout.

This re-investment becomes an issue, if there is any concern that the time value of
money may be different during this [provision for abandonment] period.
 Project
Parameters
 Abandonment Expenditure and Sinking Funds
It is useful to be able to introduce an explicit assumption about investment opportunity
during this phase of the project.

The “Extended Yield” method assumes that cash flows, immediately preceding
abandonment, are set aside and invested at an explicit rate, to be available to meet the
financial obligations associated with abandonment.

Such an investment may be called a “sinking fund”, ie a fund created to meet a future
obligation.
Project
Parameters Foinaven has a relatively modest abandonment cost, because of the mobile nature of
the facilities.

In Table 54 it is indicated that the investment required in period 20 is £56.3 million.

The Extended Yield method starts at Period 20 and moves backwards in time
seeking cash flows to set aside to cover 56.3.

An explicit assumption about investment opportunity is made. Let us assume 8% here

to reflect reduced investment opportunity.
 Project
Parameters
 Abandonment Expenditure and Sinking Funds

With each backward time-step, cash flow

requirement is discounted at 8%, reflecting the fact
that our sinking fund will grow over time at 8%.

56.3 in Period 20, becomes [56.3 / 1.08] 52.1 in

Period 19.

In that Period, there exists a cash flow of 71.8, which

Project is more than sufficient.
Parameters
52.1 is set aside for the sinking fund and [71.8 - 52.1]
19.7 remains.

The 52.1 within its sinking fund will grow at 8% to

become 56.3 in Period 20, to pay for the
abandonment.

In the project cash flow, the data in Periods 19 and

20 are replaced by 19.7 and zero, see Table 55.
 Abandonment Expenditure and Sinking Funds
The column headed “EY[0.00] “ provides the Extended yield calculation. In this case, there is no discounting
and 500 must be allocated from NCF into the sinking fund from Periods 13 to 19. In the 10.0% case, the
EY[0.10] calculation includes discounting and 371.4 is allocated to the sinking fund from Periods 15 to 19.

Project
Parameters
 Acceleration Projects
An acceleration project is one in which the main objective of the investment is to bring
production forward in time.

In the context of Petroleum Engineering, these projects are very common and important as they
include a wide range of activity such as work-overs, infill drilling, gas compression etc.

Project
Parameters
 Project
Parameters
 Acceleration Projects
When converted into Incremental Revenues, this results in positive [incremental] Revenues in
Years 6 to 11 and negative [incremental] Revenues in Years 12 to 15. When combined with
Capex and Opex, this creates a characteristic cash flow distribution with two phases of negative,
with positive in between.

Project
Parameters
 Acceleration Projects
More than one phase of negative cash flow was discussed earlier in the context of IRR
calculation and when the second phase becomes significant, there is the issue of multiple
roots to consider.

Because IRR is the solution to a complex equation, there is a realistic possibility of

multiple roots arising, under particular circumstances.

Project
Parameters
 Project
Parameters
 Acceleration Projects
Surprisingly, perhaps, as the discount rate increases, the resultant NPV’s become less
negative and turn positive between 10 and 15 percent.

NPV continues to increase to a maximum of around plus 30, at a discount rate of about
25% and then starts to decline, finally becoming negative again at a discount rate of about
45%.

Project
Parameters
 Project Screening
In the context of project evaluation, screening is the process of comparing projects
against a set of standard criteria.

Here specifically we consider project cash flows and measures of profitability. In a

wider context, screening would encompass aspects of geology, technology,
geography, politics etc.

There, it was demonstrated that discounting project cash flows at a specific rate
could be used as a means of testing whether an investment was growing at that rate.
Project
Parameters

If a company decides that it requires a return of 12 percent from its investments, it

should discount all project cash flows at 12 percent.

NPV[0.12] equal to zero indicates that the project will give a return of precisely
12 percent.

If the NPV[0.12] is positive, the return is higher than 12 percent, if NPV[0.12] is

negative, the return is lower than 12 percent.
 Ranking Parameters

Project
Parameters
 The classic dilemma is whether to rank by NPV [£] or by IRR [%].

Figure 93 includes NPV profiles for two projects, A and B Project A has an
undiscounted TCS of 50 and an IRR of 50%.

Project B has an undiscounted TCS of 80 and an IRR of 36%.

Project Below a discount rate of about 21%, B has a higher NPV, but A has a higher IRR.
Parameters So which is the better project when these parameters rank differently?

In pursuing this line of argument, it is important to remember that these financial

criteria represent only one of several aspects of project rank.

Secondly, cash flow data is someone’s perception of the future and accordingly
suspect.

The first step in any interpretation of discounted cash flows is to ensure that the
discount rate is appropriate.
 If there is doubt about the actual value, use an appropriate range.

In this case, we assume a discount rate of 12% and note that the curves cross
at a higher value [about 22%].

Consequently, our data informs us that Project B has a higher NPV and Project
A has a higher IRR.
Project NPV is a measure of profit and ranking by NPV identifies those investments,
Parameters which will generate the largest profits.

In this example, at a discount rate of 12%, Project B will produce a profit of

£44 million and Project A, £34 million.

The following issues may be relevant: NPV reveals nothing about the size of
the investment or indeed about investment efficiency, it is simply the surplus.

In this case, the investment could be £50 million or £500 million. Larger projects
will generally have larger NPV’s [doubling all cash flows doubles NPV].
 Project
Parameters
 Annual Capital Charge
In an investment situation, where a uniform, positive cash flow is expected, analysis
can be simplified considerably by applying the principles of the annuity [Section 4.7].
Uniform cash flows may be expected in investment relating to manufacture or
transportation.
Recall that the present value of an annuity may be represented by:

Project
Parameters where “P” is the Present Value of a series, in which “A” represents a uniform annual
cash flow.

The Annual Capital Charge analysis is based on a slightly modified version of this
equation in which “1” [P/P] represents one unit of investment and “a” [A/P] represents
the Annual Capital Charge Factor [ACCF].

In this context ACCF is the uniform annual revenue [positive cash flow] as a proportion
of one, which must be generated over the life of the project [“n” years] to justify the
initial unit of investment.

The Discount Rate “i” represents the relevant time value of money or required return
on investment.
 Project
Parameters
 Corporate Tax

What is the difference between stand-alone and consolidated

corporate tax models?
Government
 Corporate Tax

The common methods of modelling corporate tax are called “standalone” and
“consolidated” [see Figure 112].

The stand-alone model assumes that the company has no other, relevant taxable
activity and that the project cash flow and company cash flow are the same.

The consolidated model assumes that the company has other relevant, taxable
activity and has sufficient taxable revenues to enable expenditure allowances to be
Government claimed immediately.
 Which companies are considered as parent and subsidiary
companies?
Government
 Exploitation of petroleum has created large business enterprise and has attracted
much attention from government.

Government involvement in the industry is considered here under the following

headings:

i. National Interest
ii. Economic Development
iii. Resource Ownership
Government iv. Licensing
v. Petroleum Development
vi. Taxation
 National Interest

National interest concerns the role, the status and the security of each state on the
world stage. It has military, political and economic aspects.

Modern military systems are dependent on petroleum-based fuels for mobility.

Examples:

World War One saw the introduction of aircraft and tanks to the battlefield, and
superior access to oil contributed to the final outcome.
Government
Germany and Japan entered World War Two with limited oil supplies.

Germany invested hugely in the development of synthetic fuels from coal and
embarked on a disastrous campaign in Russia in an attempt to capture the
Caspian oilfields.

Japan invaded Indonesia, specifically to gain control of oil production.

The Allies [USA and Britain] had superior oil supplies and this advantage again
had a significant bearing on the ultimate outcome of the War.
 Economic Development

National economic development is a complex process, based on the

exploitation of available resources including human and material, indigenous
and imported.

Consumption of energy is sometimes used as an indicator of economic

development and Table 63 clearly indicates the very wide variation, which
exists, both in terms of world regions and of individual countries.

Government One of the major problems facing the world community is how to enhance
standard of living, without further damage to the environment.

The 1997 Kyoto Protocol [UN Framework Convention on Climate Change] is

an attempt to limit emission of carbon dioxide and other greenhouse gases.

After six years, the Protocol has insufficient support to come into force.
Government
 The Paris Agreement

Climate change is a global emergency that goes beyond national borders.

It is an issue that requires international cooperation and coordinated solutions at

all levels.

To tackle climate change and its negative impacts, world leaders at the UN
Climate Change Conference (COP21) in Paris reached a breakthrough on 12
December 2015: the historic Paris Agreement.
Government
The Agreement sets long-term goals to guide all nations:

substantially reduce global greenhouse gas emissions to limit the global

temperature increase in this century to 2 degrees Celsius while pursuing efforts
to limit the increase even further to 1.5 degrees;

review countries’ commitments every five years;

provide financing to developing countries to mitigate climate change, strengthen

resilience and enhance abilities to adapt to climate impacts.
 Conflict of ownership

Over the past 50 years, most of the world’s continental margins have been
subdivided and allocated to coastal states.

Given the geographical and political complexity of the world, this has been
a long, difficult and contentious process.

Islands are a common source of conflict.

Government
Caspian Sea

The Caspian is an enclosed sea, which historically was bordered by the

Soviet Union and Iran.

These states had signed treaties in 1921/40 agreeing to share resources and
navigational rights.

There was no mention of minerals in these documents. In 1991, with the fall of
the Soviet Union, Iran was joined by Russia, Azerbaijan, Kazakhstan and
Turkmenistan and offshore petroleum resources became a major issue.
Government
 Licensing

The term “licensing” is used here to identify the process of granting permission
to explore for and / or to produce petroleum.

It is implied, that permission is granted by the owner of the resource, and that
the licence therefore has appropriate legal status.

As indicated in Section 6.3, the owner of petroleum resources in the subsurface

is normally the government, but could be the land-owner, or another company
Government or individual.

In the text, which follows, it is assumed that ownership is vested in government.

Frequently, government is represented by a national oil company [NOC],

which may or may not have the technical capability to operate independently.

The production of petroleum is a capital-intensive process, which may

generate substantial revenues over a long period of time.