The Evaluation Of Exploration And Production Ventures In An Inflationary Environment
Authors: Mortada M. 
Published: December 2007

The inflationary environment of the past several years has contributed a new dimension to the risk and uncertainty encountered in evaluating investments in exploration and production ventures. Predicting the rate of inflation even for just a few Predicting the rate of inflation even for just a few quarters is not usually reliable. Predicting the rate of inflation for the expected life of a producing venture, which in most cases may be a few decades long, is meaningless. The rate of inflation, nevertheless, impacts both the cost and the revenue sides of the equation.

To cope with this problem, analysts usually postulate several scenarios for the rate of inflation postulate several scenarios for the rate of inflation and its impact on revenue and expenses. The draw-backs of this approach are:–The rate of return thus derived is a function of the assumed rate of inflation.–It does not measure the real profitability of the investment.–It cannot be effectively used to compare investments of differing economic lives.–The internal rate of return overstates the profitability of the venture and creates the illusion of unjustifiably high profits.

This paper proposes the use of the DCF real rate of return method for measuring profitability of investments in exploration and production. This method circumvents the drawbacks outlined above. The conceptual framework for the DCF real rate of return method is developed and its significance to the investor is analyzed. Examples of applying the method to investment decisions are presented.

Introduction

Investments in exploration and production have some basic characteristics which distinguish them from most other types of investments. In addition to the risk and uncertainty associated with exploratory effort, investments in exploration and production have an economic life which spans a production have an economic life which spans a few decades. The investment begins with a period of negative cash flow which may, upon the discovery of a commercial accumulation, be followed by a period of positive cash flow until the economic limit period of positive cash flow until the economic limit is reached and the project is abandoned. During the period from the initiation of investment in exploratory effort until abandonment, considerable changes in the social and the economic environment will occur, and major changes in the rate of inflation will have materialized. Taking the rate of inflation into consideration adds a new dimension of risk and uncertainty to the evaluation process. Since inflation seems to be endemic to Western society, its effects on investment profitability must be clearly understood and analyzed.

EFFECTS OF INFLATION

The effects of inflation on an investment decision are felt through three separate and usually different rates of inflation.–The rate of general inflation, ig, usually referred to as the GNP deflator–The GNP deflator affects the purchasing power of the future cash flow and is used to convert the cash flow from current to constant money having equal purchasing power.