Oil&Gas Projects

Assessment, management and development

Economics

Экономика

 

 

Project development is a complex process consisting of several blocks, each of which is important. The whole project success crucially depends on the precise interaction of these blocks.

 

We emphasize once again that the key indicator of finding the optimal vector of the project development is an economic performance. At the same time, the role and importance of the latter increases if the design process is based on an iterative scheme with close cooperation of technological, economic, financial and legal parts of the project team.

 

Let’s consider a project of the oil asset development, that had been worked out by the authors during their own industry practice.

 

We have an oil field, which was already put into production, at the same time, it has a significant reserve growth potential and, therefore, the possibility of production increase. As an initial iteration the best scenario from technological point of view was worked out: we assumed sequence field drilling with horizontal wells and sidetracking on the existing well stock. This option allows you to increase production in the shortest possible time. However, key performance indicators of this scenario were disappointing. We carefully analyzed the obtained results: for example, a significant part of the capital costs accounted for the initial phase of the project; also, field development required the construction of oil collection and preparation facilities. We were not satisfied with this scenario, although given the criteria of economic efficiency; it looked like clearly better in comparison with current situation.

 

Then we continued our research. As a result, another options were developed, which differed in drilling schemes at different rates (number of drilling crews) and types of operations (drilling of new horizons or sidetracking at the operating fund). All developed options were ranked in terms of specific efficiency. Finally, the optimum scenario was found, which assumed phased new wells drilling with the staged construction of collection and preparation systems. The found solution helped us to increase the profitability of the project from 14 to 17%.

 

If the interdisciplinary interaction was organized sequentially (from geologists to developers, then to infrastructure designers and finally to economists), finding the optimal solution would have taken much longer time, or, that is most likely, we would be satisfied with the originally found solution, "elegant" in terms of technical expertise. Investors probably would not be interested in this project: the work is done - the result is not achieved.

 

Oil and gas industry, as well as any other industry, is specified by a number of features:

 

    - High capital demand - development of even a "small" oil and gas project needs million dollar investments and, as a result, industry is characterized by long pay-back period;

 

    - Many uncertainties regarding the physical characteristics of the field, which necessitates a thorough work on the analysis and identification of risks;

 

    - Significant volatility and unpredictable nature of the prices - oil and gas are among the most liquid assets, the price of which is the most «market» one, so we have a significant level of uncertainty, even at short planning periods;

 

    - High "politicized" industry - the budgets of many states are critically dependent on tax revenues from the oil and gas industry, which has prompted renewed interest in it by the state;

 

    - A large value of the tax burden - the stability and efficiency of the tax system depend critically on the fate of the individual projects, and even the entire companies.

 

These specific features make it possible to compare the oil and gas projects and medical activities with  the presence of common feature - the crucial importance of diagnosing stage and initial analysis, where the wrong decision on the tactics can lead to death of the patient, or in our case, the closure of the project.

 

So, as you can see from the described features of the oil and gas industry, one of the keys to success seems to be the competent analysis of the risks and uncertainties associated with the implementation of a specific project.

 

Murphy's Law states that if there is a possibility that something bad can happen, it will definitely happen. Therefore, the project team should always be ready to implement a plan of action in this regard.

 

We should agree that the desire to know anything seems almost unattainable ideal, and therefore industry accepted a "scenario" approach to the economic analysis of oil and gas projects.

 

Minimum requirement of the project team is to develop several options taking into account uncertainties in reserves and production levels. As our practice shows, variation of only geological and technological component of the project appears to be insufficient. A good addition to the analysis is to study several options of the product transportation (given the current level of logistical constraints, it seems to be necessary). This remark mostly applies to the oil fields, but does not lose its relevance to the gas projects.

 

A key approach in this area is a netback comparison using various channels of product monetization. Netback price means the price of products at the target market, net of transport costs and mandatory payments to the state, in other words, with respect to the oil and gas industry, the price of hydrocarbons at the outlet of the oil and gas company.

 

This work is quite relevant, since even the price difference of a few dollars, in the context of the production volumes of the project, turns into millions of dollars of lost profits, or additional income, depending on the effectiveness of the decisions taken.

 

Netback analysis is quite a difficult task, since the analyst should have a broad base of information, regarding not only prices of products at different markets, but also the cost of transportation and related services. This information often is not public, and requires a deep understanding of the industry. Because all members of our project team gain invaluable experience in large and medium-sized Russian oil and gas companies, we can share some of the results of our work and analysis.

 

Fundamental differences of the analysis related to oil and gas is following: oil and oil product markets are global, that is why there is a wide range of options to sale product to various consumers all over the world, as for the gas, it requires particular end user and the necessary infrastructure (LNG terminals / pipelines).

 

 It should be noted the usefulness of the expansion of the analysis object by considering the secondary product as well - gasoline, diesel, fuel oil - for oil, ethane, LPG, SNG, helium - for natural gas. In order to do this, the netback analysis should consider the cost of processing, as well as the cost of capital used for the development of this production.

 

Proposed approach allows us to consider more options and, subject to the strategic decision of the investor and economic feasibility, may increase the total revenue from additional investments in processing.

 

Even if there is a strategic decision to focus on the production of primary products (oil, dry gas), in-depth netback analysis could provide a competitive advantage in negotiations with potential buyers of primary product, as it allows to "find" the ultimate price, they could pay.

 

Along with the above-mentioned options, you should give due attention to explore the type of product you are going to produce (oil / petroleum, gas / LPG, condensate / oil, etc.). To answer this question you should consider the overall strategy of the Company. Nevertheless, it is important to analyze in detail all possible sources of value of the project, including, the subsequent sale of an asset or attraction of a partner for a joint project.

 

The authors evaluated one asset, located in the eastern part of the Russian Federation. If we consider the project in the traditional way: a complex of exploration and subsequent development of oil reserves and oil sales in the domestic and foreign markets - the results would be disappointing, the project did not seem to be interesting, taking into account significant geological risks.

 

A possible way to look at the project from a different angle is the revision of the target product - as this formation contains oil with a significant part of a valuable component, which has a steady demand in the world petrochemical market. We considered an integrated production scenario: upstream (production) and downstream (refining). Although the project required higher amount of investments, but in terms of profitability it is equal to the most profitable oil and gas projects in the region, given the higher added value of the oil components.

 

This approach to risk management will be helpful in case of non-confirmation of planned production levels. We could compensate profit with refinery cash flow, which will be guaranteed by refining of third-party oil: favorable location of the site allows us to offer other oil producers in the region reasonable price.

 

An important aspect of the project activity is the analysis of possible synergies in the project development. The most common synergies could be found in transport infrastructure. This is explained by the effect of scale - the cost of the object grows more slower than its capacity. In other words - it is cheaper to build a pipe for the two fields than for each one. Experienced experts could argue that, saying, a separate transport system will reduce the technological risk level. Sure, it's true, but to reduction of these risks could be achieved by other instruments, such as legal and contractual relations.

 

When working in one oil company, authors considered a project aimed to increase the value of a mature oil asset. Given the high degree of depletion, the asset held lower positions in the ranking of the company's portfolio. However, the field had reasonable amount of free gas undeveloped reserves, but start of production was postponed due to infrastructure cost constraints.

 

In order to study the possible options we considered neighboring assets, including third-party companies to combine gas flows in the single transport corridor. As a result, the most attractive option was to cooperate with another company, which owned the neighboring asset. Updated economy, assuming construction of a single pipeline, had turned very attractive and beneficial for both parties.

 

The obtained solution allowed monetizing previously undeveloped reserves and obtaining significant additional income. Another aspect was the extended life of the project, the preservation of employment rate and collective motivation of company personnel, which is also very important in general and for our company in particular.

 

Therefore, we walked through the key features of risk mitigation and uncertainties of the project. Finally, we have only one uncovered area, which is the most difficult one - price and macroeconomic assumptions. Prediction of oil prices – shall they grow or fall in future– is similar to gambling on red or black at the casino, that is why forecasts assuming growth or decline in prices are equally good (or bad). A possible solution is to evaluate the project at three price scenarios (often called pessimistic, optimistic and probable). The task of the project team is limited to the choice of design decisions, which, at minimum, allow not losing money in case of the pessimistic scenario realization.

 

An alternative approach is to develop a single integrated scenario that takes into account, as a rule, the downside price risks.

 

In 2010-2012, when market prices for oil were in-between 90-110 $ / bbl, the majority of Russian oil companies made investment decisions at 75 $/bbl scenario. The current situation confirms the correctness of the chosen approach.

 

These two options could be described from both positive and negative points. The only thing that we would like to mention: the more options you have worked out, the better you know the project, so more likely that you will chose the most optimal solution. The presence of several pre-developed options allows you to respond more quickly to external challenges and manage the project effectively. Naturally, in volatile oil prices condition, it may seem that it is better to be "conservative" than "optimistic" - that strategy can help you at least not to lose money.

 

A good illustration of excessive "optimism" when making investment decisions is the current situation with shale oil business in the US: a number of investment banks predicted the imminent bankruptcy of the "small" oil producers in the US, due to the sharp decline in world oil prices in 2014.

 

The main drawback of "conservative" approach is the possible adoption of non-optimal solutions. When we consider the project, taking into account a discount to the current market price, we decide to develop the most effective reserves, leaving less attractive ones undeveloped. This leads to the loss of potential income, as market conditions allow us to develop much larger volume of reserves, rather than in "investment" conditions. Thus, the use of deeply conservative pricing assumptions leads to loss of investments and potential revenue of the project.

 

To sum up: the best solution to overcome the price uncertainties is the scenario approach, i.e. development of several scenarios of the project at various price levels. At the same time, we should choose the base case option, taking into account the level of the equilibrium price in the long run. The base case scenario, in addition to the price factor, should be based on the expected (i.e., which has the maximum probability) reserve levels and guaranteed production profile. Despite the fact that the project has some potential, the option with additional growth in reserves should be considered only as a supplement to the base case (upside). Of course, should have a positive economy even with the additional downside risk.

 

We have seen that the "scenario" approach is the most important way to reduce the uncertainties and risks in the economic analysis of the project. How, then, should we take decisions on the future of the project, having only a set of numbers and values?

 

In our practice, we use one of the most effective approaches - development of a decision tree and the calculation of the expected value (EMV). When you need to make decisions under uncertainty, when each one depends on the outcome of the previous decision, then a scheme called decision tree is used.

 

For each alternative we calculate the expected value (EMV) is the sum of products of the net present value estimates of the scenario and the probability of its successful implementation for all possible options. As an example, let us consider the decision tree for the exploration project, as shown in the figure below.

 

Картинка

 

Usually it takes the first year of the project to close a purchase deal of a license (by the auction from the state or directly from another company), and the costs could vary from a hundred thousand to billions of dollars, depending on the volume of reserves or prospective resources.

 

The next 5 years usually takes to proceed through a complex geological exploration, minimum scope of works is usually shown in the license for subsoil use. As a rule, when geological survey is completed, it is possible to estimate the resource potential of the license and forecast production profile.

 

Let’s consider the following scenarios as the next steps:

 

    - Lack of recoverable reserves (pessimistic scenario);

   

    - Minimum amount of reserves (conservative scenario);

 

    - Expected amount of reserves (base scenario);

 

    - Maximum amount of reserves (optimistic scenario);

 

We should evaluate all scenarios, and assign for each one the probability of its realization. 

 

This stage of evaluation contains a very subjective component. In this case, if the company lacks competencies, a method of «expert assessments» could be applied.  This is an easy solution of the problem, which could provide a high level of objectivity.

 

In our case, the expected value of the project is 46 million $. This figure could be used as a benchmark for comparison of alternatives investing options.

 

 To simplify the decision criteria: the sign of the expected value really matters - a "positive" sign indicates, that the project could be implemented, "negative" - ​​it is necessary to abandon it, as the fail is the most likely scenario. However, please keep in mind what science has developed the concept of "probability" – it is a probability theory, econometrics and mathematical statistics. The key feature here is statistics, which is a set of sufficiently large number of observations. In other words, if we want to use EMV indicator to evaluate the project, it should be understood, that a positive value guarantees us that only if we implement some amount of these projects (with similar characteristics), we do not lose money.

 

Let’s go further. Parlaying on one project with a high level of risk and highest expected value may not lead to success, and even more likely lead to a complete disaster. That is why oil and gas business is the most global industry in the world. Here global companies are playing first violin, and they have assets at various stages of development and in different regions of the world. We are talking about a portfolio of projects as a way to reduce risks in the industry practice. For this reason, for medium and large companies the task of constructing a balanced portfolio is very important.

 

On the one hand, exploration assets (without proved reserves) are quite a risky target for investment. Indeed, the average success of drilling an exploratory well is 10-30%, which means  that, at best, two of the three wells drilled, each costing tens of millions of dollars, will be "dry". On the other hand, the search assets:

 

    - do not require huge amount of capital right now, as is case of producing assets;

 

    - are much cheaper (because of the risk of reserve non-confirmation and some other factors);

   

    - have a probability of discovering higher amount of reserves than expected (which assumed in the purchase price);

 

    - ensure future production for the company in the medium and long term (to recover already produced reserves).

 

In contrast to these characteristics, assets with proven reserves are characterized by:

 

    - less risk of reserve non-confirmation,

   

    - higher specific value,

 

    - limited reserve addition potential,

 while keeping the risk of designed production profile failure.

 

Summing up on the block "diversification of investments in the oil and gas business," we want to note that the important thing for any company is to find the optimal combination of risk and return, to ensure reserves recover and prevent decline in production in the future. An important aspect is also the issue of maintaining a balanced structure of the company` cash flow.

 

Likewise, companies are trying to diversify its portfolio geographically. As a rule, regions with low political risk, stable tax system and strong political institutions, have long history of international business activity (the North Sea, for example), so here we could find mostly mature assets and the potential of new discoveries tends to be limited. On the contrary, new oil and gas provinces with high reserves discovery potential, are located mainly in developing economies, which level of stability is significantly lower, compared to the traditional regions, geological risks are higher, but the potential investor` reward is promising. That encourages companies to develop more and more areas (Venezuela, Russia, Iran).

 

As an illustration of the thesis about the importance of diversification, let`s observe Repsol case of  nationalization of its Argentine assets, which accounted for about 1/3 of the total production of the company.

 

In April 2012, the Argentine government decided to nationalize a controlling stake of YPF (51%), which was owned by Repsol. Argentine authorities claimed Spanish taking out capital from the country, under-investing in producing oil fields, causing environmental damage. Argentine Senate approved the proposal.

 

Repsol` share price track in 2012 is illustrated in the figure below.

 

Картинка

 

 

In conclusion, we would like to discuss in some detail how the comparison of options is made, which guidelines managers use to choose one or another alternative.

 

Current practice is based on several key indicators: net present value (NPV), internal rate of return (IRR), the coefficient of return on investment (PI) and payback period (usually discounted - DPBP). Historically, the most popular indicators are NPV and IRR.

 

To begin with, it should be noted that none of the economic efficiency indicators do not allow to compare real investment in a correct way.

Investors tend to have several alternatives. It can be various projects or different strategies of project development. Thus, the investor faces a challenge not only to evaluate the effectiveness of a particular project, but also to choose the best option from several alternatives. In our practice, there are situations where it is impossible to compare the effectiveness in terms of IRR, as the IRR may not exist (when leverage is used) or have several values. There are situations when IRR contradicts NPV. We will show this in the following examples.

 

IRR does not exist for the following cash flows:

 

 Period

0

1

2

3

4

NCF

(net cash flow)

1000

-2505

1400

700

-490

 

And if we change some numbers in that row ​​of NCF:

 

 Period

0

1

2

3

4

NCF

1000

-2505

1320

700

-490

 

we obtain two values  of ​IRR: 15% and 28.2%.

 

IRR contradicts NPV for the Project A and Project B, with the following cash flows:

 

Period

0

1

2

3

4

NCF А

-250

100

100

100

100

NCFB

-250

50

50

150

175

 

For k = 10%, we NPVA = 67 mln., which is less than NPVB = 69 mln. Hence, the project B is more profitable than A . But IRR gives us the opposite assessment: IRRA = 22%, which is higher than IRRB = 20%.

 

NPV itself also does not provide a clear answer when comparing alternatives.

 

Lets compare project C with project D, where NCFC = -100, 59, 64 million rubles (at 0, 1, 2 steps, respectively) and NCFD = -150, 62, 64, 66 million rubles.

 

Period

0

1

2

3

NCFC

-100

59

64

 

NCFD

-150

62

64

66

 

We assume that the investor, who compares alternative C and D, has 100 mln. rubles and he loan another 50 million at the same rate (i.e., k = 10% for C and D). So, NPVC = 6,53 mln., and NPVD = 8,84 mln. rubles and it seems, that project D is the best option.

 

However, in reality project C is the most effective one. We can prove this as follows. Let’s divide NCFD into investor cash flow (NCFD investor) and partner cash flow (NCFD partner) in proportion to their contributions (100/150 - the investor's share, 50/150 – partner`s share):

 

 

Period

0

1

2

3

NCFD investor

-100

41,3

42,7

44

NCFDpartner

-50

20,7

21,3

22

 

We will obtain the following values: NPVD investor = 5,9 million rubles., NPVD partner = 2.95 million. Thus, if investor choose project D, he will obtain the worst alternative - it would wipe NPV (in the amount of 6,53-5,9 = 0,63 mln.), and postpone pay-back of investments.

 

In this regard, we focus in our work not on one or two economic indicators, but take into account a set of parameters, including the strategic context of the company` development. This approach ensures the most effective result for the customer.

 

It is sad to say, but we should stop our paper here, since we don’t set the task to grasp the immensity. This section is intended to show the complexity and non-triviality of the decisions making process in the oil and gas industry. We purposefully did not take into account the political and geopolitical factors and scenarios with a speculative component. Although, in this paper we do not go them around. After all, global trends determine the effectiveness of any business. Forecasting and accounting for the project development strategy allows you to create the most effective and least risky scenario or solution tree. The last one allows making the best decision and maximizing the investor's income.

 

03.04.2015