Profitability Analysis-Where Are We Now?
Authors: Silbergh Michael , Brons Folkert 
Published: December 2007

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The two predominant profitability criteria in general use today are Dollar Profit discounted at the firm's cost of money and Discounted Cash Flow Rate of Return. Of the two, the former is a generally satisfactory and reliable screening and ranking yardstick; Rate of Return, however, has serious shortcomings and should be used only with great caution, if at all.

General Introduction

By comparison with the engineering time, talent, and effort that are usually involved in an oil and gas venture, the profitability analysis of that venture is simple. Yet the process of profitability analysis holds a particular fascination for almost any engineer, for here is the payoff; here is where he finds out if it is "go" or "no go"; here is where there may be a new job, or no job, a commendation or a "too bad"; for it is uniquely the engineer who is supposed to produce the proposal, the recommendation to undertake a technical venture at a profit - and the bigger the profit, the better. Although a review of profitability usage shows that widely accepted profitability criteria have always had a basic conceptual simplicity in common, this is not to say that the preferred criterion has always been the same, or even remained the same for any great length of time. This paper is directed at the working petroleum engineer, who does not specialize in profitability analysis but who makes such analyses in the course of practicing his profession. That the reader is quite familiar with the subject is therefore assumed. There is a difficulty in presenting a review paper to a knowledgeable audience it is all too easy merely, to "plow old ground," leaving the reader bored and no better informed than before. We hope to avoid this by NOT presenting yet another set of derivations of discounted cash flow rate of return, discounted value profit, cost of money, or any of the equations dealing with risk or uncertainty, or the statistical theory that underlies these concepts (these analyses can be found in the references). Rather we hope to provide a bridge whereby the profitability analysis provide a bridge whereby the profitability analysis experts, the nonexpert profitability analysis makers, and the decision makers who use profitability analysis can better understand one another's requirements. We also expect to place the present state of the art within its historical context because we believe it is useful not only to know where you are, but also how you got there, and where you may be going!

Historical Introduction

The time value of money has long been recognized, and the search for improved profitability criteria has been continuous, but time-related profitability criteria did not gain wide acceptance in the oil industry until the late 1950's. During the post-World War II development drilling boom, oil companies were producing some 20 percent net returns on net shareholder investment; money was available at 3 and 4 percent interest rates, and in all, management perhaps did not feel a compelling need for highly refined profitability criteria. profitability criteria.