Essay on Petroleum Economics: Examining Factors to Make Investment Decisions

Introduction

Economics in petroleum engineering entails the employment of methods of economic assessment at every phase in the growth of oil and gas exploration and production ventures. Through the examination of economic factors, such as the level of information concerning the oil or gas site, market environments, and the influence of tax or royalty, enables petroleum economists to make investment choices (Fanchi & Christiansen, 2017). Other economic factors vital in petroleum engineering includes the location, type, and several wells. Besides, economists in the oil and gas industry deliberate on the net cash flow, payout, and return on investment (Brown, 2016).

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Such factors help in making effective decisions on whether or not to start drilling and exploring petroleum wells, or whether or not to develop a whole gas production scheme. Petroleum economists also consider the scrutiny and management of the economic, technical, and other risks related to various stages of petroleum projects (Fanchi & Christiansen, 2017). The purpose of this paper entails the examination of economic factors in the petroleum industry, such as the net cash flow, payout, and return on investment that influences investment decisions.

Net Cash Flow (NCF) in Petroleum Engineering

The net cash flow in petroleum engineering businesses consists of various modules, some positive while others negative. Net cash flow refers to profit, which entails revenue minus costs. Capital expenditure (CAPEX) refers to the entire investment the company makes in the petroleum project, such as laying pipelines, costs of drilling wells (like tubing, casing, and completion), manifolds, and treatment (Brown, 2016). CAPEX gets paid at the start of the project. However, sometimes CAPEX gets acquired in the course of executing the plan like when effecting secondary rescue approaches that require extra surface competences like water injection reservoirs and pumps, or after the project during plugging and desertion of the site.

CAPEX consist of tangible and intangible costs. The substantial costs refer to any procured touchable or visible physical aspect of the project. Real prices depreciate typically, that is, the value of the product decreases over time. Intangible costs refer to untouchable or unnoticeable components of the project (Brown, 2016). Invisible costs undergo amortization (permits the decrease in the worth of the elusive element over a fixed period). The recovery approach and schedule of the payment get influenced by the inflation rate.

Operating expenditure (OPEX) involves the entire costs linked to the fluid lift from the wells to the surface, distillation, treatment, shipment, and reservoir workover. Secondary operating expenditure recovery has more necessities, hence always higher than that for primary improvement (Fanchi & Christiansen, 2017). Depreciation refers to an accounting technique of assigning the expense of tangible asset over its useful life and defines the decrease in value. Devaluation always appears in the net cash flow model as a subtraction from the organization's income before tax.

The more significant the devaluation, the lesser the income and vice versa. Mathematically, economists calculate depreciation as follows:

• DDB rate = Depreciation percentage/ the time of a particular asset.
• Depreciation deduction at that year = DDB rate actual drilling cost.
• Straight Line (SL) = Tangible drilling cost/ the use of a particular asset.

Economists suggest the selection of the method that results in a more significant devaluation since it indicates a low-income tax for each precise year in the net cash flow model (Fanchi & Christiansen, 2017). Amortization refers to an accounting method of decreasing the cost price of intangible properties through planned augmentations. The formulas for calculating depreciation includes:

• Written off immediately = Amortization rate Intangible drilling cost.
• Balance = Intangible drilling cost - written off immediately.
• Straight Line (SL) = Balance/ the useful time of a particular asset.

Royalty comprises of the payment compensated by the drilling firm to the ores' right proprietor, usually the government. Operating tax refers to the percentage charges an organization, or an entity gets for the services by the administration. Various governments impose corporate and operating tax on energy and petroleum companies operating within their jurisdiction. Inflation refers to the average rate at which the price level of commodities escalates over time. Inflation rates affect the net cash flow (Fanchi & Christiansen, 2017). Therefore it remains a vital component in the model as it ensures that the economic forecast remains more convincing. A rise in inflation rate results in an upsurge in costs, hence detrimental. The discount aspect in a net cash flow framework entails the interest rate employed to define the present value of future revenue.

The net cash flow has an exceptional feature referred to as time zero. Time zero refers to the day the contracts receive a check to start implementing the project. Capex is assigned time zero in the net cash flow (NCF) model. Thus:

NCF (i) = Capex (i) + Opex (i) + Sales (i)

Payout

Payout refers to the anticipated monetary payment or financial yield from a venture or annuity. Economists describe payouts on a global or intermittent basis as either a percentage of the business' budget or in a real dollar aggregate (Brown, 2016). Payout also refers to the period in which a project or investment may earn its original money invested and become nominally productive. The payout or payback period, therefore, examines various investments and establishes the most cost-effective project of business. Payout considers the time in years needed to regain the value of an investment from the commencement of the project until the increasing net cash flow curve goes positive. Economists argue that all investments should target a shorter payback time (Brown, 2016). The payout in the oil and gas sector takes between five to seven years.

The maximum cash out of pocket (maximum harmful exposure) of the project refers to the first payment at the initial stage of the project as CAPEX. Return on maximum cash out of pocket refers to an economic instrument employed to establish the revenue by dividing the NCF by the maximum negative cost. The approach signifies time preceding to the payout period.

Return on maximum cash out of pocket = Net cash flow (NCF)/ maximum negative value.

Return on Investment (ROI)

Return on investment (ROI) estimates the profit or loss on investment compared to the sum of cash spent. Return on investment helps in economic judgments in comparing the productivity of various investments (Fanchi & Christiansen, 2017).

ROI = (Net revenue after royalty - Opex - Operating Tax)/ total investment.

ROI = (Annual return 100)/ Investment.

Discounted return on investment (DROI) refers to an ROI approach that accounts for the period through a discount rate. Return on investment, therefore, gives the ratio between net profit and investment cost (Fanchi & Christiansen, 2017). A more significant ROI signifies the investments' benefits equate positively to its price. ROI examines the productivity of an investment or compares the cost-effectiveness of several investment options.

Conclusion

Investing in petroleum requires sound analysis of economic factors that play a vital role in its exploration and extraction. Like any other product, petroleum markets have factors that influence their operations, such as demand and supply, cost of exploration and extraction, production expenses, and refining costs. Economic factors like payout period, return on investment, and net cash flow impact on major decisions on whether to take the risk and invest in specific regions and periods. The above factors also influence profit margins, time to start receiving income, and the general feasibility of the project since oil and gas exploration projects take time, expensive, but have huge returns. A mistake can result in unprecedented loss.

References

Brown, T. (2016). Engineering economics and economic design for process engineers. CRC Press. www.books.google.com/books?hl=en&lr=&id=40ArBgAAQBAJ&oi=fnd&pg=PP1&dq=Economics+in+petroleum+engineering&ots=EoUuXLHoeX&sig=INXK1re8KptpKxUOZX9hGj7AdZY

Fanchi, J. R., & Christiansen, R. L. (2017). Introduction to petroleum engineering. John Wiley & Sons, Incorporated. www.onlinelibrary.wiley.com/doi/pdf/10.1002/9781119193463