ELT Executive Report Kasriel & Wood, December 2011 p. 1 of 52
Knowing when to quit: timing petroleum field abandonment decisions to optimize Net Present Value
Ken Kasriel
RPS Energy, London, U.K.
& David Wood
DWA Energy Limited, Lincoln, U.K.
Executive Summary
If the aim of investment activity is to maximize value to the Investor, then the time to end the activity is when the Investor believes maximum possible value is achieved, before value is destroyed by continuing. To prevent such value destruction, upstream petroleum industry investments usually have some form of economic limit test (ELT) which determines that it is time to stop a project when forecasted “value” (i.e. some definition of revenue minus some definition of costs) would otherwise turn permanently negative.
While this is appropriate, we believe that industry participants commonly use ELTs which are flawed, because they are based on the wrong measure of value. Although the industry does generally agree that the point of investment is to maximize value, specifically post-tax Net Present Value (NPV) of future Net Cashflow (NCF) – i.e., all revenue received by the Investor, less all costs incurred by the Investor, discounted using an appropriate discount rate – in practice, commonly used ELT calculations erroneously measure something else.
· Although potentially quite material, abandonment costs and income taxes are usually ignored. In fact the latest (November 2011) Petroleum Resource Management System (PRMS) guidelines sponsored by the SPE, SPEE, AAPG, WPC and SEG explicitly reiterates its previous (2007) stance that these two cost items should be excluded when calculating cashflows for the ELT. We suspect that one reason for excluding abandonment costs is that a calculation of when to abandon a project, based on abandonment costs which depend on when they are incurred, leads to an arithmetic circularity (detailed later in this article). Moreover, in cases where abandonment costs are income tax deductible, an inability to calculate abandonment costs leads to an inability to calculate income taxes, which could partly explain the exclusion of income taxes from the PRMS ELT calculation. Whatever the reasons for the exclusions, abandonment costs and income taxes are real cash outflows which should not be ignored.
· Many ELTs for investments we have seen, which are governed by production sharing contracts (PSCs), simplistically define Investor revenue as [(total field revenue) times (the Investor’s working interest).] This can give misleading results, as an Investor’s working interest share of PSC revenue – which consists of both reimbursement for actual costs incurred, and revenue shared with the host government under a specific formula -- is more complex to calculate, and often lower, than the Investor’s simple working interest share of total field revenue,. We suspect that one reason that actual PSC revenue is not used in ELT calculations is that abandonment costs are often eligible for reimbursement to the Investor; therefore, if abandonment costs are ignored, then Investor revenue will be distorted in the ELT calculation.
· Many ELTs for investments we have seen are based on undiscounted cashflows.
Thus ELTs with these flaws end up designed to maximize not the Investor’s NPV, but rather a less meaningful variant thereof, because they exclude certain Investor costs, simplify (and thus distort) Investor revenue, and / or ignore the time value of money.
To be clear: in our experience, Investors do consider all these items, and do so correctly, when calculating NPV; the problem is that when calculating ELTs, they calculate something else. If maximising Investor NPV is the point of investing, then both the valuation and ELT calculations should focus on the same thing.
Here we present a simple, transparent and mathematically sound approach to calculating the ELT which avoids arithmetic circularities and the shortcomings mentioned above. By considering all actual Investor cash inflows and outflows (including abandonment costs) and the time value of money, this method permits == to the extent that any forecast model can -- timing the abandonment decision to maximize Investor NPV. To illustrate, we present four plausible and detailed valuation models in Microsoft Excel format. In these cases, our ELT method results in abandonment timing decisions which result in Investor NPVs which are materially (~30% to ~50%) higher than using a method with the aforementioned shortcomings. (The materiality of any such benefits in other cases will, of course, depend on the specific assumptions used in those cases.)
Introduction
Petroleum economic models should incorporate an economic limit test (ELT), which determines when a field should be abandoned on commercial grounds, even though continued, but commercially unviable, production is technically possible.
The aim of devising an ELT is to replicate in the model the behavior of an “Investor” – our term here for the party empowered to make the abandonment decision -- assuming this entity is an economically rational agent, i.e., that it wishes to maximize the value it gains by selling production derived from the field.
Common industry practice, in models used for both internal business planning and for regulatory reporting purposes, is to calibrate the economic limit to maximize a field’s expected gross operating cashflow (GOCF). We define GOCF as a field’s total ”gross” (here, meaning 100% working interest basis) revenue, minus total gross recurring cash or cash-equivalent costs (e.g., royalties, taxes other than income taxes, , opex, etc.) but excluding capex and abandonment costs. GOCF is usually not discounted.
We believe this common approach is flawed, given the general industry consensus that the best measure of value to an Investor is not total field GOCF, but rather the Investor’s share of Net Present Value (NPV)—i.e. the sum of discounted future net cashflow (NCF), which accounts for all cash and cash-equivalent costs (hereafter, “cash costs”), including the time value of money. An abandonment date designed to maximize Investor NPV will not necessarily be the same as one designed to maximize field level GOCF. This discrepancy can arise because GOCF ignores potentially material cash outflows.
One such outflow ignored in the GOCF calculation is the abandonment expense – both its amount and the timing of the cash payment, whether comprised of periodic payments over the field’s production life, or a single lump sum at incurred at or after production ends. A likely reason this cost is excluded in conventional ELT calculations is that to try to include it in a cash flow model can easily lead to a circularity, whereby one needs to know the abandonment date in order to determine the ultimate (i.e. inflated, then discounted) value of the abandonment cost; but to know this ultimate value of the abandonment cost, one needs to know the abandonment date. (Attempting to solve this circularity via iteration is not recommended, as detailed later.)
The inability to account for abandonment costs when using GOCF to calculate the ELT has distorting knock-on effects.
1. Abandonment payments are often income tax deductions, ignoring them precludes correctly calculating income tax. We note, in fact that in the recently issued Guidelines for Application of the Petroleum Resources Management System (November 2011), the sponsors (the Society of Petroleum Engineers, American Association of Petroleum Geologists, World Petroleum Council, Society of Petroleum Evaluation Engineers and Society of Exploration Geophysicists) explicitly state that the ELT calculation should ignore abandonment costs and income taxes:
“Economic limit is defined as the production rate beyond which the net operating cash flows (net revenue minus direct operating costs) from a project are negative, a point in time that defines the project’s economic life…. Operating costs should include only those costs that are incremental to the project for which the economic limit is being calculated. In other words, only those cash costs that will actually be eliminated if project production ceases should be considered in the calculation of economic limit. Operating costs should include property-specific fixed overhead charges if these are actual incremental costs attributable to the project and any production and property taxes but (for purposes of calculating economic limit) should exclude depreciation, abandonment and reclamation costs, and income tax, as well as any overhead above that required to operate the subject property (or project) itself.” [Emphasis added by Kasriel & Wood]
We fault the idea “only those cash costs that will actually be eliminated if project production ceases should be considered in the calculation of economic limit” because abandonment costs do not fit this definition – they are a liability which will not be eliminated when the project ends – but this does not mean they should be ignored. They are real and often material cash outflows.
2. Under production sharing contracts (PSCs), abandonment payments are often cost recoverable, and so determine a major source of Investor revenue, i.e. “cost petroleum;” thus, ignoring them precludes correctly calculating the Investor’s share of contractor revenue.
We propose a method to calculate an economic limit which maximizes Investor NPV – which again, accounts for all Investor cash costs, including abandonment costs -- in a way which side-steps the aforementioned circularity.
Our method, which is very simple, both conceptually, and to implement /verify in common software packages such as Microsoft Excel, is
· to run the economic model once for each conceivable abandonment date (e.g., in an annual model with a 10 year timeframe, to run the model 10 times, each time assuming that abandonment occurs in a different year); this can be accomplished with a short, simple VBA macro, obviating the need to build multiple copies of the model
· to collate the results of these models
· to choose the abandonment date which results in the highest Investor NPV. This is the abandonment year which should be used – or if not, should at the very least be the starting point for discussions about the optimum time to abandon the field.
Objectives
In this article, drawing on the attached Excel files, we:
· show, in simplified, illustrative examples, how to calculate the economic limit using variants of the GOCF-based approach – which we term “Method A” -- and using our Investor NPV-based approach -- which we term “Method B”
· compare, in more complex and realistic examples, the results of Methods A and B, thereby demonstrating that Method B can result in abandonment dates which materially enhance Investor NPV.
Method A explained
Method A: the flawed and the less-flawed approaches
Showing the advantages of Method B over Method A requires first demonstrating how Method A works. This in turn requires showing and remedying a common flawed approach used to calculate Method A. In other words, although we believe Method A to be inferior to Method B, we want this to be a “fair fight”, by comparing the better (though still flawed) version of Method A to Method B.
It is first necessary to distinguish between the flawed and less flawed variants of Method A via the following example.
Note: here and elsewhere in this article, “mm” means “million”.
Figure 1: simple calculation of annual and cumulative gross operating cashflow (GOCF)
Figure 1, above, shows a calculation of GOCF, ignoring any economic limit, for a field which, after incurring $2 million in general & administrative opex in 2012, starts producing the next year. Technically, the field can produce through to the end of 2016. Once production starts, opex exceeds revenue twice, in 2014 and 2016, resulting in negative GOCF in those years. Annual and cumulative GOCF are plotted in Figure 2, below.
Figure 2: plot of annual and cumulative GOCF from Figure 1, above
Some modellers mistakenly apply Method A by making the field, once production has started, shut down before any GOCF loss can occur. In this example, this approach would result in the field shutting down in 2013, when cumulative GOCF reached $38 million. This is wrong because, by taking the first production-period instance of negative GOCF as the trigger to shut down the field, the ELT fails to “look ahead”, thus ignoring any future events which could improve on this cumulative $38 million. Variants of this approach – e.g. using logic to allow for a set number of consecutive periods of GOCF losses – share this flaw; there is a limit to how far they will look ahead.
A better (though still flawed, compared to Method B) variant of Method A considers GOCF throughout the entire technical production life, and ends the economic field life in the last period before GOCF turns permanently negative. In effect, this defines the last year of economic production as the year of maximum cumulative GOCF. In the example above, this improved approach recognises 2015 as the year when GOCF peaks at $68 million, and designates it as the last year of economic life, to be followed by abandonment.
This second, cumulative –GOCF-based variant of the ELT is what we mean by “Method A” for the rest of this article. We show in detail how to calculate and use Method A in Figure 3, below and in the following discussion.