Optimization of Capital Expenditures In Petroleum Investments
Authors: Campbell John M. 
Published: December 2007

As the petroleum industry has embraced the concept of rate of return as an investment criterion, numerous papers on the subject have appeared in the literature. The purpose of this paper is to clarify the significance of these methods and extend their application. Because of space limitations, no attempt has been made to duplicate these previous efforts. Instead, the emphasis has been placed on proper utilization of the results. Discussed are:the problem of multiple rates of return on acceleration projects;effect of time on comparative results;development of realistic mathematical model; andformal consideration of probability in the economic evaluation.

Several reasonable solutions to these problems are presented.

Introduction

The rate-of-return concepts embraced by the petroleum industry in the last few years represent techniques that have been widely employed by other groups in the fields of finance and banking for the past century. In the process of attempting to utilize these "new" methods in the industry, many modifications of the basic compound-interest equations have appeared. Refs. 1 through 11 out-line the more popular approaches used. In their preoccupation with obtaining numbers, many have lost sight of the inherent characteristics of many equations used, as well as the real goals of investment. Put another way-rate of return as found by any equation, no matter how good, is not in itself a satisfactory investment criterion. Any economic decision involves either formal or informal consideration of the following:risk factors, includingprediction of future events. and economic climate andprobability of success or failure;rate of return on investment;effect that failure(s) would have on an organization's economic future;tax ramifications;current investment needs and opportunities;cash generation needs in future years to remain in a sound and dynamic position (might involve deferral of revenue for economic reasons);romance factors; andan organization's financial structure.

The detailed discussion here will be limited to Items 1 and 2. Usually, these are the ones formally considered by the practicing engineer, while the remainder are usually management prerogatives. Some understanding, though, of Items 3 through 8 is essential for intelligent engineering appraisal. Space does not permit a complete discussion of those latter factors, but a few comments are essential. In theory there is always an infinite number of investment opportunities available for the investment dollar. In practice this is never really true. There are always limitations imposed by organizational policy, personnel capabilities and governmental interference in economic affairs. A decentralized region, area or division, for example, has certain geographic limitations that restrict investment potential. An oil-company management is not likely to seriously consider a project to manufacture television seas unless they have an insufficient number of attractive oil investments. If they do consider it, they must include in their cost considerations the acquisition of new qualified personnel. Most managements inherently limit the largest portion Of their investments to areas where they have experience and are in a position to make qualified judgment decisions. This is one reason why diversification is necessarily slow. No comment should be necessary about the limitation imposed by governmental regulation. It must also be recognized that not all investments are profit motivated. Some are made for strategic reasons. Strategic here means that said investment is necessary to achieve long-range company goals. This class of investment must necessarily strengthen the organization so that it enhances the probability of success of profit-motivated investments. One example of this is represented by funds expended for laboratory research and field tests (pilot floods, special tests, etc.). These cannot be compared with profit-motivated investments by means of a single yardstick, such as rate of return, because strategic investments yield a return that is impossible to measure in dollars and cents. Can anyone cite the cash flowback resulting from research, public relations, college aid programs and similar efforts? No! Yet, any enlightened executive recognizes their value. The eight factors previously listed are primarily important in profit-motivated investments, which comprise the bulk of all investments made. No finite discussion is possible on such things as the romance factors.

JPT

P. 708^