Petroleum Project Cash Flow

The period at which the cumulative NCF reaches its maximum value defines the economic limit of the project. After reaching this peak, the cumulative NCF begins to decline. Continuing the project beyond this point does not add value but instead diminishes it. Therefore, the field should be shut down at this point.

Broadly, as outlined above, an upstream project involves investing capital over time in the short term (the first few years) with the expectation that the project will generate positive cash flows in the long term, exceeding the initial investments. To determine whether the project is a profitable proposition, a consistent method of valuing cash flows (both spent and received) at various points over an extended period is required. The method used by economists is called Discounted Cash Flow (DCF).

The key is selecting an appropriate cost of capital to discount the cash flows. The cost of capital sets a benchmark for the project's overall return. If the project’s returns exceed the cost of capital, this indicates that the value for shareholders and other investors has increased.

In practice, project cash flows are discounted using a range of discount rates. One of these rates reflects the company’s cost of capital, while others are used as sensitivity analyses to assess the impact of different discount rates. The rate corresponding to the cost of capital provides the true value of the project’s cash flows, while higher rates are typically used for screening purposes.

Often, a matrix of NPV results is created at varying discount rates and oil prices to evaluate how changes in these factors impact the project's value. Since neither oil prices nor discount rates can be predicted with certainty, this matrix is extremely valuable for management to assess the project’s value.

The use of debt in a project is sometimes referred to as “gearing.” Generally, the NPV of a geared project is higher than that of the same project financed entirely with equity. However, this does not necessarily mean that a geared project is superior to an ungeared one. If a loan makes a project profitable, theoretically, there is no need to proceed with the project—one could simply take out a loan.

For this reason, it is advisable to run the economic base case with an assumption of 100% equity financing. Sensitivity cases with debt financing can then be run to evaluate the impact of debt on the project.

Once the project's cash flow has been constructed, it is necessary to assess which project is the most suitable among many. Economists use several indicators to evaluate the project's feasibility under given conditions. It is needless to say that NCF is the primary indicator resulting from a cash flow model. The main purpose of creating a cash flow model is to determine the total net after-tax cash flow of the project (and the partners, of course). However, decisions cannot solely rely on NCF, as it does not account for the time value of money. Below is a discussion of economic indicators commonly used in the upstream industry to assess and value projects.

NPV is the most widely used measure of project cash flow value. If NPV is positive, it indicates the project is adding value at the assumed discount rate. The project with the highest NPV is considered the best in terms of value creation. NPVs are additive, meaning that the sum of individual NPVs gives the NPV of an entire project portfolio. NPV represents the excess cash generated after covering the cost of capital, making it one of the best proxies for shareholder value.

However, NPV has limitations when comparing projects under constraints. It does not account for the size of the project or the capital required to generate the given NPV. Additionally, NPV requires an estimate of the appropriate cost of capital for discounting cash flows.

The IRR (Internal Rate of Return), also known as "Earning Power," is another widely used indicator. If the IRR of a project exceeds the cost of capital (or the hurdle rate), the project can be accepted. IRR is useful as a screening tool, and unlike NPV, it accounts for capital size by indicating the return on investment. This makes IRR particularly helpful for comparing projects with different capital investment levels. IRR shows how effectively a project generates returns on its investment.

A drawback of IRR is that smaller projects may have much higher IRRs than larger projects, which could have higher NPVs. Investing in smaller projects may not add more value than investing in larger projects with higher NPVs. Therefore, NPV ranks projects based on value, while IRR ranks them based on capital efficiency.

To combine both value and capital efficiency, Discounted Profitability Index (PI) and Profit/Investment Ratio (PIR) are used. These should be calculated at the company’s cost of capital. The PI is calculated as 1 plus the ratio of NPV to the present value (PV) of Capex. PIR is the ratio of NPV to PV of Capex. A PIR of 0.5 means that for every $1 of Capex (in present value terms), the project generates $0.50 in net cash profit.

These indicators are particularly useful when Capex is a significant constraint. PIR in the industry is known by various names such as Present Value Ratio (PVR), Value Investment Ratio (VIR), or NPV/NPC (Net Present Value over Net Present Cost). Typically, Opex is excluded from the PI, PIR, and VIR calculations, though some may include it.

Another indicator used to measure risk is the Exposure Adjusted Profitability Index. This is simply the ratio of NPV to the maximum exposure of the project. This indicator is valuable when a company may have short-term financing issues and wishes to assess the project on this basis. A higher ratio indicates lower risk, and vice versa.