Inflation & Escalation
Intro
You can keep going recounting hundreds of specific item whose prices may have gone up (or sometime down). And the price rise for these items will go up or down by different amount. When you want to express the average total price increase of all goods then you use the term inflation. And you would say inflation has gone up (or down, in which case it is called deflation) say by 3%. That does not mean all goods and service price has risen by 3%. Some of them may have risen by 10%, 15% or may have fallen by 5%.
Let’s consider your monthly expenses on living costs such as food, utility bills, phone bills, entertainment, commuting, etc., which amounted to $1,000 last year. This year, these expenses have increased to $1,040 despite the consumption of the same amount of goods and services as the previous year. This scenario demonstrates a $40 increase in costs.
Inflation is the average increase in prices across an economy.
Many analysts use the terms inflation and escalation interchangeably; however, they are distinct concepts. Inflation is the overall cause, while escalation is the effect on specific items. Escalation pertains to the price increase of a specific commodity, good, or service. For example, the price of petrol, beer, or electricity may escalate.
The prices of these specific items can fluctuate independently, and their individual rates of change will vary. When referring to the overall average price increase across all goods, the term inflation is used. One might say inflation has increased (or decreased, referred to as deflation) by a certain percentage, such as 3%. This figure does not imply that every good and service has experienced a uniform price change of 3%; some might have increased by 10% or 15%, while others may have decreased by 5%.
Let’s look at a specific example. When crude prices crashed by more than 50% in the latter part of 2014, not all prices fell by the same percentage. Rig rates fell significantly, but home prices in and around London did not decline. In fact, they continued to grow by about 10%.
Often, when a project is sanctioned, the estimated cost of laying a pipeline might be $X million. By the time the project is completed, the actual cost could have increased to $2X. Therefore, inflation would have risen by 100% during that period. There is a clear distinction between inflation and escalation, yet many analysts either fail to see this distinction or choose to ignore it for simplicity in calculations.
The rise in the price of a specific good can be due to various factors, such as inflation, demand growth, supply shortage, technological changes, political, and environmental issues. It could be one factor or a combination of these factors.
Most investment projects, especially in the upstream Oil and Gas industry, have a lifespan of more than a decade, sometimes up to 50 years. When project cost estimation is done, it is based on current costs. However, when the time comes to pay for these expenses in the future, the actual cost is likely to have increased (though it can occasionally decrease). Therefore, evaluating project economics without accounting for rising costs would not reflect true economic profitability. When evaluating long-lived projects, it is essential to incorporate the effect of escalation (and thus inflation) on project economics. Not only costs but also revenue will be affected by escalation (typically positively).
One way to address the inflation/escalation issue is to analyze project economics using the actual revenue and costs expected to be incurred in the future. This can be referred to as nominal term economics. Various terms used in the industry, such as “Money of the Day”, “Nominal”, “Inflated”, “Escalated”, and “Outturn”, essentially refer to the same concept.
To understand "nominal" money, it is necessary to understand "real" money. "Real" money refers to hypothetical money with purchasing power equivalent to the current purchasing power of the money (of the same currency), which remains constant over time. For example, $100 today is "real" money. Due to an inflation rate of 5%, today's $100 (real money) will be equivalent to next year's $105 (nominal money). “Real” money is also termed “constant” money or “deflated” money.
A “nominal” value is expressed in MOD and includes the effects of inflation and other factors influencing price changes. The “real” value removes the impact of inflation, showing how future money translates to today's terms.
When analyzing the economics of investment projects, another method is to use “real” or “constant” money. This involves discounting inflated money at a rate equal to the inflation rate at the reference date.
Will there be a difference in the conclusion of the economic analysis if we apply “real” money valuation or “nominal” money valuation?
The answer is no. Economists evaluate projects by comparing them with alternatives that create maximum value. If a project maximizes value in “nominal” terms, it should also maximize value in real terms among the alternatives. Neither method is superior.
However, when analyzing multiple projects, consistency with the method of analysis is crucial. One cannot use the “nominal” basis for one project and the “real” term basis for another. Both must be analyzed in either “nominal” or “real” terms, but never mixed.
For multinational companies evaluating projects in multiple countries, it becomes slightly complex. Economic evaluation is based on the DCF (discounted cash flows) method. The discount rate depends on the cost of capital, which is influenced by the individual country's inflation rate. A country with high inflation has a high cost of capital and a high discount rate, while a country with low inflation has a low cost of capital and a low discount rate. When MNCs have projects in multiple countries, each project is discounted at different rates, making comparison difficult.
One solution is to construct cash flows first in “real” terms, then convert them into the local “nominal” currency of the country using appropriate inflation factors and exchange rates. After calculating and taxing in local currency, convert the final after-tax cash flows into “real” US dollars. This ensures all projects are evaluated on the same basis.
Another reason to convert “nominal” cash flows into “real” cash flows is that nominal money will have different purchasing power in different periods. To ensure comparability, it is better to convert all cash flows to the same purchasing power value, i.e., in “real” terms.
PROJECT EVALUATION PROCESS
First, estimate the costs (Opex and Capex) of the proposed investments. Look at the current market prices for different goods and services and develop the values of Opex and Capex as if all those expenses were to be incurred today, the reference period of the project (normally what it would cost at the time the estimate is made). This money is called Estimate Date Money (EDM) or Base Year Cost (BYC).
For example, let’s say the field development plan for a shallow water offshore field in Nigeria involves drilling 50 wells over the next five years. Today, it costs $25 million to drill one well in the shallow offshore region using a Jack-up rig. The plan is to drill 10 wells each year over the next five years. So in today’s money (which is our “real” term or RT money), the plan has $1,250 million (50 x $25 million) as drilling Capex in “real” terms.
PROJECT EVALUATION PROCESS
First, estimate the costs (Opex and Capex) of the proposed investments. Look at the current market prices for different goods and services and develop the values of Opex and Capex as if all those expenses were to be incurred today, the reference period of the project (normally what it would cost at the time the estimate is made). This money is called Estimate Date Money (EDM) or Base Year Cost (BYC).
For example, let’s say the field development plan for a shallow water offshore field in Nigeria involves drilling 50 wells over the next five years. Today, it costs $25 million to drill one well in the shallow offshore region using a Jack-up rig. The plan is to drill 10 wells each year over the next five years. So in today’s money (which is our “real” term or RT money), the plan has $1,250 million (50 x $25 million) as drilling Capex in “real” terms.
The subsequent step in the process involves converting "Real" term drilling capital expenditure (Capex) into "Nominal" money or "Money of the Day" (MOD). This conversion is essential because our estimate is based on current monetary values. Over time, various factors, including inflation, will cause the cost of drilling these 50 wells to increase beyond today's prices.
To convert our "Real" term drilling estimate into "Nominal" or MOD cash flow, it is necessary to account for expected inflation and other factors that may affect costs. It is important to note that individual items may not experience price changes at the same rate as suggested by the general inflation rate, which is based on the economy's overall price index. Therefore, specific adjustments for each item are required in addition to the inflation rate.
While many analysts employ a constant inflation rate to adjust costs and prices, the chosen rate should align with the company's economic outlook. It is crucial to apply a consistent inflation rate across all periods, despite potential fluctuations, recessions, or deflationary scenarios. Determining the appropriate inflation rate is subject to the company's corporate policy.
Similarly, different cost items such as drilling a well, laying pipelines, constructing offshore platforms, and installing subsea systems may not escalate at the same rate. These components can exhibit varying escalation rates both among themselves and over different time periods.
For instance, an increase in oil prices typically elevates the demand for drilling rigs, leading to a sharp rise in rig rates. Concurrently, construction activities intensify, putting pressure on fabrication yards. Consequently, the escalation rates for these services might exceed the general inflation rate, each following its own distinct higher rate.
It is important to note that in the diagram above, EDM and RT are not depicted within the same period "t=0", which serves as the base or reference date for EDM. When rolling back MOD to RT using a discount factor known as a deflator, it is expected that MOD would align with EDM once converted back into RT. However, EDM and RT monetary values may not necessarily match.
This discrepancy arises due to two main reasons. Firstly, EDM may not be deflated to the same reference or base date as EDM. Secondly, during the escalation of EDM to MOD, it is multiplied by a factor influenced by inflation and other market variables. Conversely, when deflating MOD back, it is not done using the same escalation factor but rather a general inflation index. In simple terms, the timelines do not align, and the deflator is not the inverse of the escalator (except if market factors are zero, in which case the escalator and deflator would be inverses).
To summarize the key points: we begin with EDM and escalate it to MOD. After converting EDM to MOD, tax and NCF calculations are performed in MOD terms. At this stage, there are two options: either conduct all economic indicator calculations and comparisons in MOD terms or convert the MOD NCF back to RT and then calculate economic indicators for comparison with other project indicators.
Both approaches are mathematically valid and will yield the same decision outcome. Nonetheless, one reason for preferring the conversion of MOD cash flow back to RT is that while MOD cash flow may appear attractive, its purchasing power diminishes over time due to inflation. Therefore, to account for this loss, MOD cash flows are converted to today’s money or RT, based on the reference/base date of EDM. Additionally, when escalating EDM to MOD, it is multiplied by an inflation and market factor-influenced escalation factor, whereas deflation back to RT uses a general inflation index. The deflator is thus not the inverse of the escalator unless market factors equal zero.
Let us now apply this theory practically. The table below outlines the inputs for a project cash flow,
assuming different annual escalation rates for Capex (10%) and Opex (8%).
The oil price is forecasted to remain flat at $60 in today’s terms, with an assumed long-term annual increase of 5%. Average inflation is projected at 3% overall. It is crucial to note that despite the forecasted increases in Capex (10%), Opex (8%), and oil price (5%), the general price index or inflation rises only by 3% annually. This is because inflation in the economy is determined by various factors beyond crude oil prices and Capex and Opex costs.
Capex, Opex, and oil price forecasts are based on today’s estimates (EDM).
We start with all inputs provided in the table (pale yellow section). Next, we calculate the escalation factors for each category of inputs for all periods.
Price escalation factor in period t = (1 + Price Escalation %) ^ t
Price in MOD terms in period t = Price in period in EDM x Price escalation factor of period
Revenue in MOD terms in period t = Production in period x Price in MOD in period t
Opex escalation factor in period t = (1 + Opex Escalation %) ^ t
Opex in MOD terms in period t = Opex in period in EDM x Opex escalation factor of period
Capex escalation factor in period t = (1 + Capex Escalation %) ^ t
Capex in MOD terms in period t = Capex in period in EDM x Capex escalation factor of period
Pre-Tax cash flow (Pre-Tax CF) is calculated as Revenue – Opex – Capex, all in MOD terms. Taxable profit is determined as Revenue - Opex – Depreciation – any losses from previous periods. Both depreciation and tax are based on MOD Revenue, Opex, and Capex. We assume a 5-year straight-line depreciation for Capex, starting from production commencement, where any pre-production cost is capitalized and depreciated. The assumed tax rate is 30%, with no royalty assumptions. Calculated tax is also in MOD terms.
Finally, net cash flow (NCF in MOD terms) is computed. To convert NCF-MOD into real terms (NCF-RT), a deflation factor is used:
Deflation factor = 1 /(1+Inflation rate)^t.
NCF in Real Terms = NCF in MOD terms x Deflation Factor.
IMPACT OF INFLATION ON CASH FLOWS
The cash flow figures calculated with and without inflation/escalation will differ when compared in MOD terms. However, they will not differ if compared in RT terms once the tax impact of the depreciation allowance has passed. The difference in RT cash flow arises due to the timing difference between Capex spend and the tax benefit through depreciation. The purchasing power of the tax relief is reduced due to the delayed claim. If Capex expenses were allowed instead of depreciation, escalation and deflation would offset each other (provided the market factor for escalation equals 1).
Certain fiscal regimes, such as the UK, allow oil companies to 'uplift' their Capex for tax purposes by a certain percentage to compensate for the loss in purchasing power due to the delayed tax relief from depreciation.
A second difference appears in the IRR. It will be higher for MOD cash flow than for IRR cash flows. When inflation is present, it significantly reduces the attractiveness of the project’s RROR (real ROR); for instance, 10% inflation reduces the RROR from 10% to only 1%.
Multiple Currencies
Most upstream E&P companies operate in multiple countries. They may be headquartered in one country while having field operations in several others, depending on the company's size.
For these companies, evaluating project economics and making comparisons between projects across various countries with different currencies, exchange rates, and inflation rates can be challenging. Therefore, it is desirable that the final cash flow and indicators are presented in the same currency and in the same MOD or RT terms.
This process is also influenced by the company’s presentation and functional currency, determined by the accounting rules the company follows. As a general guideline, the following steps reflect common practices among large companies in such situations:
All cash flow elements should be calculated in the MOD currency in which the transaction occurred. They should then be converted into the MOD of the local currency using actual or forecasted exchange rates. After this, the MOD of the local currency is converted into the MOD of the parent company’s currency where it is based. Finally, the MOD parent company’s currency is presented in RT parent company’s currency.
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