Upstream Project Screening

When evaluating upstream projects, a common question is whether the project meets a specific threshold or hurdle. Project screening involves assessing if the minimum required criteria are met. If the economic indicator shows that the project has achieved the minimum threshold limit, it passes the screening test and can be considered for investment. If it fails, the project is discarded and no further evaluation is conducted.

One common screening tool in the upstream Oil and Gas sector is the IRR (Internal Rate of Return). The threshold or hurdle rate should cover the cost of capital plus an extra margin for company and project-specific risks. For example, if the hurdle rate for IRR is set at 25%, a project with an IRR of 20% will be rejected, even if the actual cost of capital is below 20%.

An investor or company without constraints can take on all projects that meet the screening criteria. However, when there are constraints, it is necessary to rank the projects to optimize the business.

Optimization can be done by ranking all successful projects that have passed the screening criteria based on NPV (Net Present Value). NPV should be calculated using the company's true cost of capital to reflect the actual value of the project.

A project with a higher IRR does not necessarily have a higher NPV, and vice versa. Decisions should be made using the NPV Profile. The NPV-based method ranks projects solely on value. For holistic decisions, other constraints such as maximum exposure, production limitations, and manpower constraints should also be considered.

For example, to compare proposals where maximum exposure is a constraint, the PIR (Profitability Index Ratio) and its exposure-based equivalent PI (Profitability Index) can be useful. When production or manpower are constraints, ratios like profit per barrel of production (NPV / PV production) may be more relevant 

Break-even refers to the point at which a project's expenses are fully covered by its revenues, resulting in neither profit nor loss. Generally, it refers to the minimum price at which a project recovers all its costs without generating profit. The condition for break-even is met when:

Break-even can be considered from various perspectives, such as pre-tax break-even price, post-tax break-even price, break-even price in real terms, and break-even price in nominal terms. The definition of break-even depends on the criteria set by the person posing the question. In the case of pre-tax break-even price, the present value of gross revenue is equal to the present value of capital expenditures and operating expenses (royalty is omitted here for simplicity).

PV of (Volume x Price) = PV Capex + PV Opex

Price x PV Production = PV Capex + PV Opex = PV Costs

Price = PV Cost/ PV Production

The break-even price in present value terms is calculated by dividing the PV of cost per unit by the PV of production, on a pre-tax basis. This can also be referred to as the pre-tax discounted Break-Even price. Although discounting production volume (barrels) is unusual, some companies utilize this concept.

A relationship between the required rate of return and the oil price can be established to demonstrate what oil price is needed to achieve a target rate of return, or alternatively what rate of return will be obtained from a particular oil price.

The Break-Even Oil price can be considered the price at which a specified economic indicator of interest for a given project equals the minimum required value. This desired economic indicator can be NPV, NCF, IRR, or even Reserves size. The break-even oil price estimated in this way becomes the minimum Oil price above which the project can be considered economic or profitable.

One method to determine the break-even Oil price is by using the NPV approach, as discussed previously. An alternative method is to use IRR for estimating the break-even Oil price. In this approach, an Oil price is established at which the IRR of the project matches the hurdle IRR rate set by management. Several IRR values are calculated under different prices until an Oil price that provides the required IRR (equal to the hurdle rate) is found. This can be easily solved using Excel's Goal Seek functionality, or by plotting a chart of Oil price and IRR and interpolating to find the break-even Oil price.

Minimum Economic Reserve is defined as the volume of commercially recoverable crude from a field that results in an NPV greater than zero when discounted at the company hurdle rate. It represents the smallest reserve size that can be profitably developed under the given fiscal contract, cost, and price assumptions.

The methodology to estimate the minimum economic reserve is similar to finding the break-even oil price. However, in this instance, the target variable to vary is the reserve size (and the associated production profile) instead of the oil (or gas) price. The process is iterative and involves running several cases with different reserve sizes (and corresponding production profiles and cost profiles) at a given price. The results of the NPV and reserve sizes are plotted, and interpolation is used to determine the minimum economic reserve size.

Unit costs refer to the cost per barrel of production, which can encompass Capex per barrel of production, Opex per barrel of production, or both. This unit cost may be presented as gross or net of tax, and either discounted or undiscounted. This indicator is particularly useful in the following scenarios:

• Ranking projects based on production rather than monetary value when production is constrained.
• Comparing costs of projects of varying sizes.
• Estimating the break-even oil price.
• Establishing tariffs for shared facilities.
• Comparing Unit NPV with the company's "finding costs".
• Valuing acquisitions or disposals on a per-barrel basis.

Technical Cost per barrel = (Capex + Opex) / Volume $/ Bbl

Unit Capex = Capex / Production

Unit Opex = Opex / Production

Essentially, the total costs are divided by the total volume produced to derive the unit costs. An example follows: Assuming a 10% royalty rate and a 40% tax rate with 200 million barrels of production.