Study on Forecasting in Oil Well Economics Finance Essay

1.0 INTRODUCTION

The quest by oil companies, stakeholders and investors in petroleum resources to reduce expenditures on oil and gas projects while at the same time increasing profit has led to increased technological development in forecasting oil well economics before investments are made on these projects. One of such developments was the introduction of a computer-based software called Petro$ in 1994 for the purpose of petroleum economics evaluation. The report which is based on forecasting of oil well economics using the petro$ software is structured in four parts to show the data the file, sensitivity analysis, an excel spreadsheet showing how the forecast can be done without using the petro$ software (a comparison of both methods) and finally a critical review of the outputs obtained from the forecasting.

1.1 FORECASTING IN OIL WELL ECONOMICS

Forecasting is the process of estimating unknown situations. In simplified term, forecasting sees the present as the key to the future. Every business, economic and investment decision making rely on forecasting since the future is not known with certainty. With forecasting, the areas of uncertainty that often surround decision with respect to capital investment, sales, costs, profits, production etc is reduced. Forecasting has turned out to be one of the most relevant aspects of planning given the uncertainty that the future holds. The need for forecasting cannot be underestimated as they can help in financial, production and economic planning, workforce scheduling and most importantly decision making. In a case where an economic downturn is envisioned, forecasting can help investors cut back on their investments. On the other hand, where a bloom seems probable, investors can use far reaching measures to maximize profits. The oil and gas industry being one that is capital-intensive with majority of her projects requiring substantial and risky investments in acquisition, exploration, operation and maintenance, rely on forecasting. The decision to invest or not in projects in the oil and gas industry usually starts with critical decision making during the exploration phase of a new project or the expansion of an already existing one. Tools used in decision making for the analysis of project risk under conditions of uncertainty help companies determine the degree of success or loss, and will determine the decision of developing or abandoning the project. The development of a detailed cash flow analyses and a comprehensive and systematic evaluation of potential investments helps determine as accurately as possible, the expected returns in the investments under various conditions of uncertainty over the expected productive life of the project. To achieve this, the development of a realistic, sound and carefully structured cash-flow projection that will reflect theA initial capital expendituresA needed for the acquisition, development, operations and maintenance of the new oil or gas prospect throughout its anticipated productive life is of paramount importance. (Oxford Management Centre, 2009). Judging from the fact that most petroleum projects require large scale investment, it is often important that decisions on investment be made on a complete and thorough analysis of variables and uncertainties as the ability to assess the viability of investments and the real value of oil and gas assets is very critical to success.

2.0 METHODOLOGY FOR DATA GENERATION NAD DATA FILE

The results obtained in this oil well economics forecasting were generated from two data sets. The projects cost currency is in million pounds (£m). The first set, the base case was given while the other case was generated by changing the product prices. The input data used for these cases are shown in table 1. The results returned obtained from running these inputs in the petro$ software returned amongst other output the cash flow analysis; and production and prices as shown in tables 2 and 3.

3.0 SENSITIVITY ANALYSISA

It is known from intuition that majority of the variables that decides any project's cash flow could be different from the values used in the analysis and that an alteration in a key input variable will definitely result in a change in the NPV. One simple method of determining the effects of a change in one or more inputs variables in a forecast is sensitivity analysis (Investopedia).Sensitivity analysis according to Megginson et al (2008) is a tool that allows analyst assess the impact of individual assumptions on decisions variable such as a project's NPV by determining the effect of changing one variable while others are kept constant. Changes in variables are assessed one after the other to identify the key variables. In sensitivity analysis, a base-case is developed via the expected values for each input while one or more variable is altered by a number of percentage points below and above the expected value, keeping all other variables constant. The input variable used for this is either increased or decreased to determine the project's NPV and IRR. This is one very useful tool for determining the consequences the actual outcome of a particular variable will have if it contradicts what the key prediction(s) was. (Besley and Birgham, 2008). The net present value is extremely sensitive to changes in the variable costs and product prices, moderately sensitive to units sold and growth rate changes and least sensitive to changes in the capital and fixed costs. In a case where the the uncertainty in the project is exceptionally high, the project maybe redesigned to eliminate the uncertainty (www.adb.org). The modelled scenario shows the sensitivity of the investment to changes in the product prices. Tables 4 and 5 shows the sensitivity report of the base case and scenario case respectively. Charts showing the output of the sensitivity run are illustrated in the figures 1-15

4.1 THE CONCEPT OF CASH FLOW ANALYSIS

Being a generic term, cash flow may mean different thing to different people depending on the context. Simply put, cash flow is the movement of cash in and out of a project or business. Inflows of cash in a business usually arise from either of investing, financing or operations while outflows of cash arise from expenses. Analyzing any business' cash flow is aimed at keeping a sufficient cash flow for the business and to give a basis for the management of cash flow. Results from a cash flow analysis can be used for the purpose of determining a projects value (rate of return), evaluating the risks in a business or investment, and to determine the potential of a business liquidity. Cash flow analysis is a very crucial aspect of a business operation as it determines the solvency of a business. Periodic cash flow analysis makes easy the identification of cash flow associated problems and can provide ways of improving the solving the problem. As far as possible, it is very crucial that a positive net cash flow be maintained.

4.1.1 DISCOUNTED CASH FLOW

In this report, the output generated by Petro$ was used to determine the discounted cash flow. Russ Bingham (2000) in "DCF models and rate of return perspective" sees the discounted cash flow as an approach of assessing performance. It uses the concept of time value of money for a project or an asset valuation. Discounted cash flow is a commonly used economic modelling tool for economic forecasting purposes where the analyst calculates the present value of a company's or firm's future cash flows. It uses a company's cash flow projections and discounts them using a discount rate to arrive at a present value. This present value is then used as a yard stick to determine the investment potential. Basically, a DCF analysis tells how attractive a business will be. The opportunity of investing in a business may be good if the results of the DCF analysis exceed the current cost of the investment. As opined by Hilton (1991), the net present value (NPV) and the internal rate of return (IRR) are primary methods used in any DCF analysis. A few assumptions exist on the use of DCF analysis. AA´ That the analysis is done in a perfect capital market; AA´ Cash flows are handled as if they were done at the end of the year; AA´The analysis treats cash flows used in investment as if they were known with certainty whereas the possibility of risk adjustments can be made in an NPV analysis to account for uncertainties in cash flow. AA´ NPV and IRR methods of discounted cash flow assume all cash inflows are reinvested in other projects that will earn more money for the business. Practically, Hilton admits that these assumptions are seldom met. This notwithstanding, the method provides an effective means of analysing investments.

4.1.2 NET PRESENT VALUE (NPV)

The net present value (NPV) is one of the discounted cash flow evaluation techniques. Because NPV gives absolutely considers the time value of money, it is seen as a sophisticated capital budgeting method that is determined by deducting a project's initial investment from the present value of its cash inflows and discounted at a rate equals to the company's capital cost. Often called the discount rate, this rate is the least return that must be earned on a project so that the company's market value remains unchanged. (Gitman, 2003). As a rule opined by Gitman (2003), a project should be invested in if the NPV equals or exceeds zero because the company will have a return that exceeds its capital cost and this will promote the market value of the company as well as its owners wealth. On the other hand, the project should not be considered if the NPV is not greater than zero as the project will give insufficient financial benefits to justify the investment especially when there are alternative investments that will at least provide the rate of return on the investment. Theoretically, this implies that a company will choose all projects with a positive NPV. In summary, Gitman postulates that where a problem of choosing between two or more projects that yield positive net present value exist, the one with the greatest NPV be selected. Being one of the most frequently used techniques of calculating the feasibility of capital expenditures, NPV is a useful tool in investment decision making for the reasons that: AA´ it appreciates the concept of time value of money that says " a dollar earned today is worth more than than a dollar earned five years from now" (Odellion Research, 2006). AA´ it is the only appraisal technique where the outputs from its analysis has direct link on the wealth of the business (Atrill et al pg 454). AA´ it gives depth and flexibility as the NPV equation can integrate other tools of financial analysis like scenario analysis as well as adjust for inflation (Odellion Research,2006). AA´ it integrates the risk affiliated with the project through the discount rate or expected cash flows (Odellion Research, 2006). AA´ it removes inconsistencies in accounting as cash flows are not representative of accounting profits but benefits of the project.NPV also determines the expected cash flow produced from the project and integrates the unique risk of getting those cash flows. The following are factors that limit the applicability of the NPV method. AA´ It is just known that a project has a +NPV or -NPV. It does not tell by how much or less the actual percentage of return is (Atrill et al, 2006). AA´ It undervalues flexibility by not giving room to future changes as new information is gathered. In other words, it uses information obtained at the time of completing the analysis to arrive at conclusions. (Odellion Reasearch, 2006).

4.1.3 INTERNAL RATE OF RETURN

Also known as economic return rate (ERR), the internal rate of return (IRR) is the discount rate (interest rate) at which the NPV of all cash flows equates zero.(investopodia). It is a commonly used capital budgeting technique by financial analysts to evaluate the viability and/or attractiveness of an investment. An investment is more desirable if its IRR is high. As such, a project with the highest IRR would most likely be considered the most excellent and undertaken first amongst a least of other projects with appreciable IRR provided all factors are common amongst the projects. It is easier to judge and make decisions using output from an IRR than other financial metrics (NPV) because of the ease of understanding and interpreting an IRR result. This notwithstanding, it should not be used in isolation but in conjunction with other comparable valuation metrics and the NPV when making a case for an investment decision.

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