Investment Decisions in Petroleum Exploration and Production
Authors: Northern Ian G. 
Published: December 2007

Economic evaluation in the exploration and production end of the petroleum industry is quite different because we are dealing with an industry in which both the diversity and extent of the technical and environmental risk is frequently greater than in most other forms of business enterprise. With this in mind, four profit indicators are discussed, with their short-comings and advantages. Payout time, undiscounted profit ratio, discounted cash flow rate of return and present value ratio or present value profit ratio are the four methods discussed with application to an actual development drilling case history. Allowances for the risk involved in development drilling and production are also discussed.

Introduction

A business historian writing a number of years from now might well look back to the middle years of the twentieth century and label them "the age of evaluation". Only a few years ago evaluation procedures that are in common use today were the somewhat mysterious preserve of financial institutions and theoretical economists. The process of translation from theory to business application has not always been easy, nor is the process of change complete. Though our industry has developed a broad base of evaluation know-how, I think it is a fair assumption that the application of economics and mathematics to the field of business management is still in an expanding phase, and that certain aids to judgment will become more effective with time. Greater effectiveness does not imply intricacy and involvement. A sound evaluation policy need not be complex. With a proper understanding of concepts, techniques and limitations, the extent to which individual evaluations should be carried and the particular characteristics that should be captured in profit indicator form become more a matter of common sense than of going by the book. Whatever form evaluation progress adopts, however, the underlying facts of life as far as the exploration and production business is concerned will remain essentially unchanged. We are dealing with a branch of the petroleum industry in which both the diversity and extent of technical and environmental risk is frequently greater than in most other forms of business enterprise. Therefore, as others have done before, let me emphasize that recourse to formal project evaluation cannot eliminate uncertainty and risk. What it can and should do is permit orderly consideration of the factors that are pertinent to an investment opportunity and produce a brief economic point of reference for management decisions.

Evaluation Criteria

Right at the outset, I would like to discard from general application in an exploration and producing setting all those profitability measures that fall under the heading of accounting methods. In this category I include all criteria that involve investment and/or income averaging to produce a percentage return on investment figure. Though these older evaluation methods may have utility under conditions of more or less equal project life and level income stream between competing projects, neither of these conditions is met in the usual range of exploration and producing investment opportunities. Instead, I would like to focus on four profit indicators that I believe do have utility in our end of the business. These are:1. Payout timea measure of the length of time required foraccumulated net earnings from a project toequal the amount of project investment;2. Undiscounted profit ratio a simple expression ofultimate net profit returned by a venture as amultiple of the total investment in that venture;3. Discounted cash-flow rate of returnthe constantrate of interest that can be earned on outstandingproject investment while permitting exact amortizationof the full amount invested over the project's usefullife; and4. Present value ratio or present value profit ratioaratio of project revenue to investment or project profitto investment, with both investment and income reducedto present value terms at a predetermined rate of interest. I propose to enlarge upon these concepts by drawing upon an actual development drilling case history. This case history involves 40 separate development drilling proposals, each one evaluated on an after-tax basis, and each without bearing any part of prior exploration expenditure.

JPT

P. 727ˆ