Investment and decision analysis for petroleum exploration

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: rashed.hamdy@gmail.com,
Dated on July 10, 2012

Abstract

Investment and decision analysis for petroleum exploration is a topic that many
explorationists, geologists, management accountants and finance managers like to know
about. This paper shows the major concepts of how investment, decision or project analysis
is made for petroleum exploration in financial view. Such analysis depends on cash-flow
models and applying capital budgeting techniques per International Oil and Gas business
practices that consider accounting concepts, taxation, and contractual arrangement that
impact on such analysis. This paper does not cover such analysis in technical view because
it is out of specialization, but this financial analysis shall be made in conjunction with
technical experienced staff to obtain some technical information of estimated reserves,
estimated initial production, chance of success and others to enable Company to prepare
investment and decision analysis.

Keywords: Investment and decision analysis for petroleum exploration; Project Analysis for
Petroleum Exploratio;, Present value of net cash flow in future for reserves, fair value of
exploration license.

For Petroleum investment, decision or practices, the major risks that can be faced
project analysis, we need to consider the by Oil Companies, the input and output of
home country taxation, production sharing the investment and decision analysis.
and joint interest arrangements, and
environmental legislations. It is preferred to
Major aspects of Production-Sharing
divide this paper into some sections; the first
System
two sections that brief the major aspects of
Presenting the major aspects of production
Production Sharing Agreement (PSA) and
sharing contracts enable management
Joint Operating Agreement (JOA), the major
accountant to know how the cash flow
aspects of taxation, and accounting
analysis should be processed.

1

Exploration and Development exploration period as minimum expenditure
Many fiscal regime in Middle East and obligation.
Africa divided the periods of the Production
Sharing Agreement’s (PSA’s) into a) For each exploration period, Contractor shall
Exploration phase that is most likely divided deliver irrecoverable letter of credit that
by two periods; first exploration period; covers the minimum expenditures
second exploration period, each having obligation, that is reduced when the
specified minimum exploration obligation Contractor meet the minimum expenditure
and expenditures that must be conducted obligation. Most of oil companies spend
within specified time limit. Each exploration exploration cost that exceeds the value of
period takes about between 2 and 3 years minimum work commitment.
that can be extended from 6 months to 2 Annual Work Program
years. b)Development phase is commencing Subject to the provisions of PSAs, the multi-
of the first Commercial Discovery of company shall conduct the required
Oil/Gas and continue for a period of 20 exploration activities during the Exploration
years and can be extended by up to 5 Years period of Exploration work program cannot
more. be changed or amended without the approval
of host government. The Exploration work
Work Commitment
Work commitment is always indicated in should be fulfilled even if it exceeds the
PSAs that covers the minimum work Minimum Expenditure Obligation.
obligation and minimum Financing & Technology
expenditure/financial obligation during the The Contractor provides all the required
exploration period. The Multi-company is financing and technology in according to the
obligated to conduct the following minimum work obligation in the PSA, and
Exploration 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 work
Production Sharing Agreement determines obligation.
how many dollars are spent during each

2

Any assignment by any partner license of all expenditures that is computed based by
or part of its interests shall be subject to multiply Base factor (that is determined at
specific rate of the Net Sales Proceeds that indicated levels of average total daily
shall be paid to host government in some production) by A factor (that is determined
PSAs. by indicated ratios of cumulative value of
production received by contactor)
Bonuses Payment
Bonuses are paid upon signing the Non-Recoverable Cost
Production Sharing Agreement that is called In the fiscal system, there are some
Signature bonus which is varied in dollars expenditures is non-recoverable from oil
depend on the prospectively of the contract production such as signature bonus, fixed
area, competition and negotiation. Also, tax and costs and expenses not related
Contactor shall pay annual bonuses to the directly or indirectly to Petroleum
host government. Kurdistan PSAs consider Operations such as
the annual bonus as recoverable costs but
Yemen PSA does not. Also, first production 1) Losses which are recovered through
bonus is paid after the first tanker lifting of insurance, any contract of indemnity
multi-company’s share, , and pays another 2) Specific bonuses paid to host
amount of production bonus that is based on government
the daily production scales or cumulative 3) Interest, fees and commissions on
productions 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 the
Production Sharing Oil marketing of Crude Oil from the
The remaining of crude oil or natural gas Agreement
after deducting royalty and cost oil from the
gross average daily crude oil produced and Cost Recovery
not used in petroleum operations, is All the following costs and expenses will be
calculated based on scales that the recovered to the multi-company by Oil Cost:
government portion is increased if the a) Operating expenses
average daily production is increased such
as Yemen and Tanzania PSAs or based on b) Exploration expenses that include
R-Factor that government portion is but not limited to, those accumulated
increased if R-factor increased by increasing prior to commencement of initial
the cumulative net revenue obtained by commercial production that should
subcontractors to the cumulative cost spent, be recoverable at specific rate.
R-factor is applied per Tunisian PSA,
c) Development expenses that include
Kurdistan PSA. As per Libyan PSA, multi-
but not limited to, those accumulated
company is entitled to crude oil in
prior to commencement of initial
percentage determined for cost recovery
commercial production that should
until cumulative value equals cumulative
be recoverable at specific rate.

3

If all costs, expenses and expenditures that For the income tax on Multi-company’s
are 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 Contractor
carried forward for recovery in the next and not be charged against the company.
succeeding Quarter or Quarters until fully
recovered, but in no case shall be recovered
Major aspects of Interest and Operation
after the termination of an Agreement
Arrangements
Administrative Overhead
Joint Operation Agreement
Multi-Company is compensated its
The type of interests between partners rather
administrative overhead for tasks performed
than government that is Working Interest or
outside host government, that is applicable
(Joint Operating Interest) which is the
to Petroleum operations under the PSA.
interest in the oil and gas in place that bears
Such 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 cost
percentage stated times the total year-to-date
and the partners share the profit oil except
exploration recoverable costs and/or specific
for public corporation of host government
agreed rate times the development,
that does not bear the cost.
production and decommissioning costs in
most PSAs. The Multi-company is not Direct Charges
allowed to recover more than the limited Operator will charge or credit Joint Venture
amounts stated in PSAs. accounts for all expenditures or credits
incurred or received in conducting Joint
Corporation Share
Operations.
Many PSAs in Middle East require the
Multi-company to carry The Public Indirect Charges
Corporation of a host government that shall An indirect charge is to compensate
not receive any cost oil, but acquires specific Operator’s parent affiliate in Home Office
rate of the profit oil. and its affiliates, for its administrative
contributions of performing services not
Host government Taxes
chargeable under direct charges for the
PSAs exempt multi-companies from any
benefit of Joint Operations. The Indirect
taxes and levies except for some specific
charge is calculated by multiplying the
taxes such as fixed tax on exploration
applicable sliding scale percentage stated in
expenditures in some country such as
Joint Operation Agreement times the total
Yemen, withholding income taxes on local
Joint Account costs excluding some specific
staff salary, some PSA exempt the
expenses. The operator cannot be
expatriate’s salaries from taxes but other
compensated more than the limited amount
PSAs impose taxes on expatriate’s salaries
of overhead that is allowed by JOA.
during development phase based on host
government taxation.

4

Farm-out/Farm-in/Carrying Interest allow taxpayers to deduct the foreign tax
Agreement 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 shall
out 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 the
transferor to transferee and the transferee key concepts of taxation of the resident
will become working interest partner for country. In our paper we will display the key
specific interest rate, and in condition to pay concepts of most international taxation. The
Farmor specific amounts to transfer part of income tax that is paid by host government
the its working interest to Farmee. The on behalf of Multi-company is not
Amounts that Farmee should pay them considered tax credit, exemption or
either is related to planned well or all deductions because multi-company does not
previous costs were previously paid by pay such taxes in most international PSAs.
Farmor based on the assigned working
interest, or/and specific amount when
producing the first discovery. Taxation
Most of multi-companies’ net income are
Carrying Interest is used specially between subject to between 30-40% corporate tax
Agent or Sponsor of Contractor/multi- rate.
company to transfer part of working interest
from assigner to assignee in condition that In most international taxation, Corporate
carried party (assignee) either pay specific should reach to taxable income, it should
amounts presently or not pay any amount immediate deduct, and not immediate
until license become productive then deduct;
working interests will revert back to the
carried party when carrying party (assignor) Corporate should not immediate deduct the
reaches payout. following:
1) Some expenditure, such as the cost
Major aspects of Investor’s Country of acquiring capital assets, is
Prevailing Laws: generally not deductible that is
Double taxation occurs when countries have depreciated over the economical life
different definitions of taxable income and of reserves.
tax rate, it rises when taxpayer is resident in 2) development drilling for petroleum
foreign country and generates income in and facility costs which is
another country such as host country. Relief depreciated over the economical life
from 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

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 are
Depreciating assets include such items as used for calculating Depletion. Depletion
computers, electric tools, furniture and calculation include only the portion of total
motor vehicles. Depreciating assets proved or proved developed reserves and
excluded from the UCA; depreciating assets production that the working interest owner is
that are capital works – for example, entitled to.
buildings and structural improvements for Book Value end of period
Production for
which deductions are available under the Estimated Reserves at X
period
separate provisions for capital works or beginning of period
would have been available if the assets had The following Capital Expenditures are
met certain conditions for the deductions. allocated over years by computing
Depletion.
Corporate can immediate deduct the a) Development Cost
following: 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

Asset Retirement Obligation such lease before signing the
Asset Retirement Obligation is future Production-sharing contract with
decommissioning costs were estimated and government. Acquisition costs is
it is treated as reduction of future net cash capitalized, but not recovered from
flows. Some PSCs such as Kurdistan require oil cost as per some PSAs. This cost
Contractor to start depositing a funds and is depleted over the life of net
making provision for decommissioning Contractor’s share of oil reserves.
costs before the end of productive contract This cost is considered as initial
by 10 years. investment if new acreage will be
acquired, but shall be considered as
Operating Expenditures sunk costs if the acreage is already
This cost is called OPEX that is referred to acquired and Company needs to
Lease Operating Expenditures which are make project analysis for other
occurred periodically and are necessary for activities.
the day-to-day operations of the field. In the
feasibility study and cash-flow model, such b) Geological & Geophysical Studies
costs are usually expressed per year per G&G cost are pre-drilling
barrel. It consists of two elements 1) indirect exploratory well; this cost includes
cost; 2) direct cost per production level. topographical, geological,
geophysical, geochemical costs. In
Opex include cost of manpower; utilities and accounting standards, the Company
materials that are consumed for operation which use successful efforts method,
activities; credits of co-products; expense such cost except the G&G
administrative and general expenses spent that is related to acquiring acreage is
for operations activities; maintenance of capitalized as acquisition cost, and
facility equipment; lifting cost; treatment the Company which uses the full cost
cost and insurance cost. method, capitalize such cost. For
Capital Expenditures feasibility study of investment or
The main characteristic of CAPEX is project evaluation analysis, G&G is
usually incurred at the beginning of a consider as relevant cost if Company
project, may be several years before any needs to decide to have G&G to drill
revenue 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

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 Contractor
d) 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

Risk and Risk Management for Foreign stock price, it was found that the Companies
Investment that pay more attention to Corporate social
responsibilities have lower medium-term
Stock price risk: return than those Companies that pay less
The market value of stock are effected by attention to such responsibilities. Means, the
various factors that will be headlines below, ethical Companies have more financial
sacrifice which is accepted by the ethical
there are factors that directly impact the
investors who pay for CSR, there are many
market valuation of stock and some factors studies enhance the positive correlation
have 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 for
short-term and long-term investors’ knowing the impact of CSR on Stock Prices
decisions. 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’ money
There is indirect factor that can impact on
can directly impact the short-term of the
the ethical investors’ or long-term investors’
stock price.
decisions which is the Corporate Social
Responsibilities (CSR) or Social Disclosure Uncertain Oil price risk:
Index (SDI) such as community Oil and gas prices are subject to high levels
involvement, environment, Human of volatility in price and demand. While oil
resources, rights and workplace. However, prices rapidly increased and decreased over
some researchers find there is ambiguity of the past years. Decrease oil prices may lead
links between Corporate Social to close some wells or license that can be
Responsibilities or Social Responsibilities non-profitable project. There are many
Index disclosed in the financial statements factors that can effect oil price that we can
and financial performance or capital market list part of them as follow
performance, but we can summarize the 1- Scarcity of natural resources (oil)
major correlation between CSR/SDI and 2- Strategic Oil stock

9

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 increasing
Insufficiency of funding risk: taxes, compulsory sale produced natural
The Company may unable to get sufficient resources via government’s control,
funds for additional capital to implement progressive labor legislation, or other
and complete its business plans on the lease activities controls that can be initially
it has interests in which make Company has imposed when Contracts signed with
no oil production interests. Therefore, there government or imposed later when
can be absolute assurance given that the Companies start violating contracts or
Company 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 and
These include the consequences of terrorist, security risks can be quantified with
political unsettlement and other activities, expected range. Each political and security
which themselves impact adversely on the risk scenario has different degrees of
economics of project or investment. uncertainty. Therefore, Company may
Expropriation of assets and terrorism are quantify such risk by estimating the
greatest risks that Oil Industry may face. probability of the each scenario that may
happened and the estimated present value of
Expropriation is not easy decision taken by net cash flows to get the Expected Monetary
government because it can lead International Value. [Daniel Johnston. 1994.
business community to impose penalties on International Petroleum Fiscal Systems and
a government that take such decisions Production Sharing Contracts. PennWell
especially 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 operate
foreign companies is not illegal in the view through a series of contractual relationships
of international law such as article 1110 of with subcontractors and non-operators. All
NAFTA and UN Resolution 1803, as long as contracts carry risks associated with the
it is done in the best interests of the country, performance made by the parties within a
for public purpose, non discriminatory basis, time and quality of work performed.
foreign company has been compensated at
market fair value immediately before The Contractor/Operator partner is not
expropriation took place. Therefore, if it is aware of any basis on which any litigation
proved 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

unprofessional manner; management following any such unsuccessful
overriding controls; differing interpretations activity; and
of obligations. 3) Increase the probability of
relinquishing the lease without
Exploration and drilling and environment recovering the capital investment.
risk: 4) Decrease the probability of obtaining
Oil and gas exploration involves significant new leases in the same Country. If the
inherent risks in predicting the location and government of host country promoted
nature of potential oil accumulations in the and marketed for the already obtained
subsurface. No Company can give absolute lease that is the one of the best leases
assurance that its exploration investment in the country, and the Company has
will result in the discovery of oil or gas, nor not had any professional drilling and
commercially recoverable. Risks in relation explorative care for this lease, host
to drilling operations or drilling work government will consider the long
structural breakdown may delay for some term economy benefits more than
months or few years due to weather or short-term and refuse to provide any
offshore conditions and shortages of critical new license or extend period of
equipment or materials. current license.
Financial and environmental risks: such
risks include drilling incidents like blow- Discovery risk:
outs, fires and oil spills. Those risks can be Any discovery may not be commercially
mitigated by safety and environmental producible. Most of explorationists use
policies, plans and procedures and will different approach for judging discovery
probabilities and chance of success. The
arrange appropriate insurances for particular
risks. No Company can give absolute successful discovery requires the trap to be
assurance against the occurrence of any of presented in position indicated by
these or other adverse events. geologists, the target formation must have
sufficient thickness, porosity and
In the event that exploration activities prove permeability characteristics must be
to 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

Risk Management: international suppliers and foreign
Risk Management include risk avoidance, employees.
risk mitigation, risk retention, and risk 5) Stop new investment and purchases
transfer, each risk scenario can be managed 6) Reduce any susceptible assets to
by one or more of the risk management expropriation or theft risks like
method depend on the nature, significance, inventories and cash
and ability of Company to face the risk. 7) Pay down liabilities to home country
suppliers
Risk Avoidance:
8) Borrow heavily from local sources.
Risk avoidance is going without an
[Daniel Johnston. 1994. International
opportunity because risk of loss is too high.
Petroleum Fiscal Systems and Production
If the expected loss is too high that
Sharing Contracts. PennWell Publishing
Company 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 companies
or refuse to invest in specific acreage. Risk Retention:
As it is known that not all risks are
Risk Mitigation:
avoidable or 100% eliminated, Company
Risk can be mitigated by reducing loss
may establish fund reserves to offset losses.
frequency or loss probability. Such as
Therefore, Some Companies start
environment risks which include well
establishing provision for meeting any
blowout, harming staff during working
probable commitment.
period, fires or oil spills, all such risks can
be mitigated by effective Health, Safety, Risk Transfer:
Environment, and Security policies and All the risks that can be mitigated, cannot be
procedures that can reduce the probability of 100% eliminated as we mentioned above,
occurring such risks. Also, Political unrest but the remaining exposure that cannot be
risks can be mitigated by the actions against mitigated to the minimum acceptable level
loss of expropriation and political unrest can be mitigated by spreading risk through
risks: farm-out, carrying interests, joint ventures
and/or insurance, which allow other parties
Reducing 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

Investment Analysis and Cash-flow in the feasibility study of petroleum projects.
Models For example, the costs that are associated
Most of Projects of petroleum explorations with already established activities of
are long-term capital investments that goes community affairs in the field that is
through capital budgeting process for incurred whatever the wells will be drilled
making long-term investment decision for or seismic acquisition will be run, shall not
Petroleum Exploration often grouped in one be accounted for such analysis except for the
of 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&A
have input variable data for making cash- should be calculated by dividing
flow analysis for their long-term investment remaining estimated acquisition cost,
decision. The input variable data are tangible development costs by
explained as below. proved reserves times production and
facility equipments are depreciated
Variables of Cash-flow Model over their useful life. Intangible cost
For estimating expenditures and income to should be amortized based on the tax
use it in the cash flow model, only the law.
estimated relevant costs and revenue that ‐ Total revenue is daily initial
will be incurred or avoided in the future production or sales multiplied by 365
based on the decision. In other word, the times oil price and times annual price
avoidable, incremental, or differential costs increase per year.
and revenue shall be considered in the cash
flow analysis. Explorationists may consider After breaking down the contents of costs
unavoidable costs or non-incremental costs and revenue to cost and revenue drivers, the

13

variable input could be easily determined as The estimated initial average daily
follow: production shall be estimated at bbls/day
from number of well
Initial Production Forecast
Various countries such as U.S issue Oil Price and price escalation
regulations or have concession agreement Crude oil that is produced from different
indicating to well spacing limitations, sources are categorized mainly according to
utilization of reservoir, and allowable its API gravity and sulfur content. The API
maximum production limits, all of those gravity of light crude oils are over 40, heavy
effect the estimated production. Also, some oils are below 25. The average crude oils
PSAs such as Kurdistan and Libyan require have 25 to 40 range. The price of crude oil is
to produce rate not exceeding Maximum dependent on API gravity and sulfur
Efficient Rate (MER) which can effect content, sweet crude oil contains less than
reservoir pressure that lead to excessive 0.5% by weight and sour crude oil contains
decline of production. more than 1.5% by weight. The higher API
gravity, the lighter oil is, the higher price
The initial production per well can be receives and vice versa, and the lower sulfur
estimated by the nearest productive well contents in oil, the sweeter it is, the higher
drilled that be expected to have the same value of oil and vice versa.
wellbore pressure and target productive
formation, or obtaining the average Many PSAs recommend calculating the oil
production of the nearest wells. cost based on the international or world oil
price market based on FOB. Even
Discovery probability, Net present value of Contractor sells their portion of oil produced
successful well, average cost of exploratory based on international market such as Brent
dry hole, Capital investment source that is traded in London and West Texas
available, and reasonable confident Intermediate (WTI) that is traded in New
probability are factors that determine the York Mercantile Exchange NYMEX or
number of well Company may need to drill. Dubai Market.
Declined production can be considered in [Morgan Downey. 2009. OIL 101. Wooden
the analysis if the Company needs to drill in Table Press LLC. Page 34-36]
the same reservoir and cannot be considered
in the analysis if Company drill the first well The oil price shall be estimated at $ per
in new reservoir because to specify the barrel Also, as we noticed recent years that
decline 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 be
known until the production run. Therefore, considered and estimated by percentage per
the estimated initial production for well or year.
all wells is constant over the economic life
of the prospect.

14

Agent/Sponsor Fees Drilling wells in the same basin is dependent
Company intends to investment in oil & gas events which need to revise or update the
industry in Middle East, should have local discovery probability that was previous
sponsor, and have sponsor agreement which calculated for the license or for the next
stated that Contractor’s should pay drilling well, but it will be independent
percentage of contractor’s profit oil to the event if they are drilled in different basin.
sponsor
[Daniel Johnston. 1994. International
Reserves Petroleum Fiscal Systems and Production
Reserves in barrels are disclosed in the Sharing Contracts. PennWell Publishing
financial 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 estimated
Geologists calculate the expected by by explorationists in percentage.
recoverable reserves based on many factors
water saturation, net pay thickness, porosity, Expenditure Forecast
and others. For estimating expenditures to use it in the
cash flow model, only the estimated relevant
The larger expected recoverable reserves in costs that will be incurred or avoided in the
the field, the more field could be attractive future as we indicated above.
and feasible, and the higher pressure in the
reservoir the more recoverable reserves can a) Expected Drilling Well
be produced in short term. The expected Preparation of drilling cost estimate
recoverable reserves of any prospect shall be is depend on type of wells, the
estimated 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 more
Discovery probability (Chance of success) 2) If the well drilled horizontal or
Calculation of discovery probability is made deviated.
by Explorationists or Geologists that can be 3) If the well is drilled at offshore
impacted on the following factors as rig costs
examples: 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

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

Squ. kilometer of 3D seismic data are considered as billable costs
with vibrator. which are carried by partners which
is offset with PSA overhead. The
d) 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 between
e) 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

Taxation Cost of site remediation and
Income tax is accounted for DD&A which is abandonment
considered as sunk cost, put taxes should be Cost of abandonment should be anticipated
deducted 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 and
Guarantee LOC/LG is non-recoverable cost estimate the present value of net cash flow
as per some PSAs, but it is compensated by for reserves after period of time for
partners if it is accounted based on gross productive or development licenses only and
LOC 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 and
The amount of LOC should be the same development licenses but for estimating the
value of the minimum work obligation. proceeds of exploration license the cash-
Bank charges rate shall be provided by flow model is not appropriate, the cost
finance team. approach will be appropriate for estimating
the value of exploration license in future.
However, the proceeds will be high roughly
estimated.

18

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 of
Those incremental cash flow have been the period.
summarized in the below figures. Figure 1
of initial cash flow which represents net

Figure 1: Initial Cash Flow*

- Acquisition cost
- Exploration Cost (include G&G and exploratory drilling wells, regardless of recoverability
concept)
- Development Cost (Include Development wells cost and facility cost)
= Initial Cash Flow

Figure 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 flows

Figure 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 environmental
Liability]
= Net Cash flow Before tax
- or + Net Tax impact (taxes or savings)

19

+ Cost of Disposed license [Remaining of non-depleted cost]
= Cash flow at disposal

*The above figures have been excerpt from 2007 CMA Learning System: Strategic
Management. Part 3. Version 2.0. IMA. Page 354-355

Discount rate and WACC Expected Utility Value (EUV)
The value of money is depreciated over EUV is the NPV which is converted into
time, therefore, for cash flow model and utility value using mathematical function
investment analysis, the present value shall which risk tolerance and net present value
be computed at required rate of return as are the main variables in the function.
discount rate, some companies preferred to
use discount rates that equal to their Risk tolerance is the risk valued in dollar
weighted average cost of capital (WACC) or which show how much the value of risk that
free-risk rate plus risk premium. Discount Company can carry. The larger value of risk
rate 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 determining
Decision Analysis the joint venture working interests that
In decision analysis or project analysis, we optimizes its participation in Joint venture.
need to use capital budget techniques and
other 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. 2nd
Net present value is annual cash flowin edition. Decision Analysis for Petroleum
times 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 more
attractive investment or project is. Payback Period
Payback period is the breakeven point or the
Expected Money Value (EMV) period of time that a company will recover
EMV is the NPV times the discovery its initial investment cost. A corporate may
probability or Chance of success in specific has a policy that determine the accepted
prospect. The higher EMV, the more payback period of any new investment in
attractive investment or project is. Company years.
management select the project or license that
have 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 report
maker is risk-seeker or averse, the risks the percentage of net cash flow to the initial
should be considered in the preference investment. This ratio accounts for time
model. Therefore, Utility function should be value of money and cannot be useful if the
considered for evaluating among projects. all or cumulative cash flows are negative.

20

The investment or project that its IRR that is Capital Investment Fund Required
greater than return on alternative use of Fund required for capital investment of
funds, required return or WACC, is reservoir is very important because the
acceptable investment, otherwise it is project might be very attractive but it will be
referred to be rejected. This technique shall beyond the ability of the company to operate
be read with NPV and PI index. and even to take the investment.

Accounting Rate of Return (ARR) or Breakeven/ Cost-Volume-Profit Analysis
Average Return on Investment Breakeven analysis could not be easy for
This technique calculates rate of the average management accountant because it depends
annual income to initial investment that on identifying the variable cost from fixed
ignores the time value of money. This ratio costs. However, operating costs area easily
may not be as useful as other techniques but to be classified between direct and indirect
some companies like to calculate this ration costs, but discovery and production cost
to know how much this investment or could be fallen into variable and fixed cost
project will contribute in aggregate net in somehow. Discovery and production
income to assets. fixed costs that are not changed in
correspondence with changes in quantities
Profitability Index (PI) of oil and gas produced. Therefore, fixed
PI 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 of
useful because it considers the time value of such cost, cumulative exploration cost can
money and size of the project. It is useful if be considered in addition to full cost of
Company needs to select several acreage or acquisition and development as fixed costs
drilling well investment that have different to determine the non-profit production that
NPV and initial investments. The higher PI cover discovery and production cost and to
is the more attractive the investment or determine the target profit from the
project will be. And PI that is less than 1 production or development license. Variable
will be rejected. cost is changed with quantities of oil/gas
Finding Cost. produced, variable costs are such ad
This ratio is used to evaluate the efficiency volerum or severance taxes, royalties, cost
of a company in adding new reserves, it of daily well operation activities.
helps a company to know how much
company carry dollars to find a barrel of
proved reserves. This ratio can be revised to
discounted costs, where, the finding costs is
divided by discounted reserves that
produced annually, if the discounted finding
cost is greater than the estimated oil price,
the project will not be attractive to enter to
development or production phase.

21

Comprehensive Example

The below data are variable input data that could be used in Cash-flow model. We will assumed that we have four licenses, one
lincense is under exploration that a Company had three prospects to be drilled, two licenses are under study to acquire one of them or
neither, 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 analysis
for 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

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 A

Please see next page that show the table of investment and decision analysis that is simply prepared. Cash-flow and decision
analysis could be prepared in more complicated form that show the annual cash flow in separate column and compute the net
reserves, net production, escalated oil prices and increased operation costs and tax more accurately based on tax laws, PSAs,
JOAs.

23

References

‐ Production Sharing Contract with Yemen Government.
‐ Model Production Sharing Contract For Exploration And Production In Kurdistan.
Available at:
http://www.eisourcebook.org/cms/Iraqi%20Kurdistan%20draft%20Model%20Production
%20Sharing%20Contract.pdf
‐ Model of Exploration And Production Sharing Agreement between National Oil
Corporation established in Libya and other. Available at:
http://www.eisourcebook.org/cms/files/attachments/other/Libya%20Model%20E&P%20
Agreement,%20Oil%20&%20Gas.pdf
‐ Model Production Sharing Contract for Petroleum Exploration and Production in
Turkmenistan (Part 1). Available at:
http://www.google.com/url?sa=t&rct=j&q=turkmenistan+production+sharing+agreement
&source=web&cd=2&cad=rja&ved=0CDEQFjAB&url=http%3A%2F%2Ffaolex.fao.org
%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: http://www.irs.gov/irm/part4/irm_04-041-
001.html
‐ U.S Treasury Regulations. Available At:
http://www.taxalmanac.org/index.php/Category:Treasury_Regulations
‐ Australian Taxation:
http://www.comlaw.gov.au/Details/C2012C00750/Html/Volume_2#_Toc338678225
‐ 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:
http://www.kadinst.hku.hk/sdconf10/Papers_PDF/p232.pdf
‐ Morgan Downey. 2009. OIL 101. Wooden Table Press LLC

24

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