Part 5.1 Petroleum Economics

Objectives After reading the chapter and reviewing the materials presented the students will be able to: Understand supply chain businesses that create new supplies of oil and gas Examine supply creation companies and how they operate Analyze factors in investment decision making Discuss calculating rates of return to evaluate prospects Explain predicting future commodity prices

Introduction Conventional supplies of crude oil and natural gas are partially processed to remove contaminates such as salt water and poisonous and inert gases and solids. They are then sent to a refiner for crude oil or a natural gas processing facility. These raw materials are converted into finished and semi-finished products to be sold and consumed. Unconventional supplies of crude oil and natural gas differ from conventional supplies in 3 ways: method of extraction, cost of extraction, and processing methods following extraction. Unconventional supplies of crude oil are extracted using mining techniques. Unconventional crude oils are tar sands, ultra heavy crudes, oil shale, bio fuels, gas to liquids, and coal to liquids.

The Economics of Creating New Supplies The Upstream Business Unit starts the entire process. It is defined as exploring, exploiting, and producing crude oil and natural gas from conventional reservoirs. The Midstream Business Unit is defined as the processing of oil and natural gas produced from the wells. This unit removes contaminants from the raw natural gas produced from the wells and delivers the methane and natural gas liquids to downstream business units via gas and liquid pipelines. The Downstream Business Unit is defined as the process of refining, distributing, and marketing unfinished and finished products. The refiners buy crude oil from producers and make products such as motor fuels and other products. The pipelines and local distribution companies buy processed natural gas and distribute to consumers to burn for heat or electricity.

Upstream Business Units Upstream Business Units produce and sell crude oil and natural gas at market price or a predetermined contractual price. The buyer is most often a downstream business unit in the case of crude oil, and a midstream business unit in the case of natural gas. Generally crude oil is sold to and purchased by a refiner on a term contract. Natural gas is sold on a term contract either to a pipeline owner or a natural gas processor.

Midstream Business Units Midstream Business Units process, treat, transport, and handle natural gas for a fee an/or a percent of the liquids value removed from the natural gas processed. The midstream business unit uses pressure and temperature control equipment to remove the natural gas liquids and remove methane. In the manufacturing process, liquids such as ethane, propane, butane, natural gasoline, and other substances such a s carbon dioxide and sulfur are extracted from the natural gas.

Downstream Business Units Downstream Business Units buy crude oil, NGLs, and natural gas from upstream and midstream business units. They use them as raw material and make finished and semi-finished products. Revenue is the life blood of each business unit. All forecasts start with projecting revenue for one to five years or longer. To stay in business all business units must invest a portion of annual cash flow as new capital to either create new supplies of crude oil and natural gas or maintain the existing physical infrastructure The reinvestment decision is based on the available cash from activities.

Integrated and Independent Energy Companies An integrated company operates in all three business units. Examples are many of the national oil companies. An independent company operates exclusively in one of the three business units. The hybrids are companies where one business unit dominates revenue generation while there are pieces of a second business unit contributing revenue.

Creating New Supplies Upstream Business Units create new supplies by drilling new wells to find new conventional supplies. They need to make annual capital investments to create new supplies. Step 1: Prospect Generation. A prospect idea is usually created by an interdisciplinary team comprised of a geologist, a geophysicist, and engineers. Their job is to identify the opportunity, estimate the amount of crude oil and natural gas in the reservoir, determine the production rate, and estimate the investment. Step 2: Lands, leasing, & Permits to Drill. The upstream business unit invests all the capital and takes all the financial and operational risks. Commonly, the lease will have 3 to 5 years to begin the process of drilling. Step 3: Appraisal of the Prospect: Before the well is drilled, it is appraised to determine the capital to be invested and the future net revenue. Step 4: Management’s Decision to Invest: Management has to evaluate the technical merits of the prospect and decide whether to invest.

Investment Decision Making Most decisions to invest are made by management comparing project costs to future revenue and calculating the project rate of return. Once a project is ready for evaluation, it is first evaluated technically, and then modeled financially. Investment in the project at time zero is the total drilling and completion cost for a new well. Annual cash flow is the revenue minus expenses. Cumulative cash flow for the life of the project is the sum of annual cash flows compared to the total amount of money invested. ROR (rate of return) gives management a measurement tool to compare projects to each other to help decide whether to spend capital on the investment.

Investment Decision Making Revenue is defined as units of crude oil and natural gas produced and sold, multiplied by the commodity price. Royalty expense also known as the cost of goods sold (COGS) is the amount of each unit produced that is retained by the mineral owner as per the lease agreement. It is generally 20 to 25% and is treated as an expense. Operating expense (OPEX) is defined as the annual cost to operate a well or wells. General and Administrative Expense (G&A) are the recurring costs associated with running a company (personnel, office rent, communications, travel, legal, etc.) and are classified as indirect expenses. Gross Income is defined as revenue less royalty, less OPEX, less G&A. Depletion, Depreciation, and Amortization Expense (DD&A) is the allocation of costs or reduction in value over the useful life of an asset. It is calculated using generally accepted accounting practices (GAAP). Depletion is the process of recording decreases in the value of minerals such as crude oil and natural gas. Depreciation is the process of recording decreases in the value of physical property such as buildings, machinery, vehicles, and land. Amortization is the process of recording decreases in the value of nonphysical property such as rights of leases, and copyrights. Tax Expense is tax on income. Net Income is gross income less DD&A and less tax. Cash Flow is defined as the net income plus DD&A and is the after tax annual free cash available for use by the company. Cash flow will be used to pay shareholders, retire debt, and reinvest in creating new supplies of crude oil and natural gas. Investment Capital (I) is defined as the cash required to drill the initial test well and to equip it for production.

Prospect Generation and Evaluation Parallel tasks include: Calculating reserves: What is the size of the petroleum reserves and expected recovery? Leasing: Is the lease available and what will it cost? Estimating the cost to drill: What will it cost to drill the well? Estimating the cost to complete and equip the well: If successful, what will it cost to complete and equip the well? Estimation and measurement are the foundation of the evaluation process. Drilling will not take place until a prospect is evaluated and rate of return is calculated. In appraising a well, possible outcomes are considered: The best case – oil and gas are found and can be produced The worst case – no oil and gas can be produced The most difficult case – oil and gas are there but they are hard to reach economically.

Prospect Generation and Evaluation Example of Petroleum Well: Proposed drilling to 10,000 feet. Estimate is 30 days to drill and evaluate the well Estimated cost: $12,025,000 Prospect generation cost: $300,000 Leasing cost: $225,000 Drilling cost to appraise the reservoir: $4,000,000 Completion cost: $2,250,000 Facilities, platform, and pipeline costs: $5,250,000

Prospect Generation and Evaluation Calculating reserves and recovery: Step 1: calculate rock volumes Step 2: calculate or estimate pore space Step 3: calculate estimated ultimate recovery Variables affecting commodity price: Supply and demand balances, weather, innovations, conservation, and politics.

Summary Conventional supplies of crude oil and natural gas are partially processed to remove contaminates such as salt water and poisonous and inert gases and solids. They are then sent to a refiner for crude oil or a natural gas processing facility. Unconventional supplies of crude oil and natural gas differ from conventional supplies in 3 ways: method of extraction, cost of extraction, and processing methods following extraction. Unconventional crude oils are tar sands, ultra heavy crudes, oil shale, bio fuels, gas to liquids, and coal to liquids. The Upstream Business Unit starts the entire process. It is defined as exploring, exploiting, and producing crude oil and natural gas from conventional reservoirs. The Midstream Business Unit is defined as the processing of oil and natural gas produced from the wells. This unit removes contaminants from the raw natural gas produced from the wells and delivers the methane and natural gas liquids to downstream business units via gas and liquid pipelines. The Downstream Business Unit is defined as the process of refining, distributing, and marketing unfinished and finished products. The refiners buy crude oil from producers and make products such as motor fuels and other products. The pipelines and local distribution companies buy processed natural gas and distribute to consumers to burn for heat or electricity. An integrated company operates in all three business units. Examples are many of the national oil companies. An independent company operates exclusively in one of the three business units. The hybrids are companies where one business unit dominates revenue generation while there are pieces of a second business unit contributing revenue. Most decisions to invest are made by management comparing project costs to future revenue and calculating the project rate of return.

Home Work 1. What are the 3 ways in which unconventional supplies differ from conventional supplies of oil and natural gas? 2. What are some unconventional crude oils? 3. What is the function of the upstream business unit? 4. What is the function of the midstream business unit? 5. What is the function of the downstream business unit?