Economics

What is Present Value (PV) and ROR?

It is the present single sum of money (normally at

time 0), from all of the individual years brought back
to the present or alternatively it is the money
invested today, at interest, to equal that future
amount or value at a future time.
It has nothing to do with inflationary effects on the
buying power of money as a function of time.
It requires applying a constant discount rate to each
of the individual years cash flow, generally
established by corporate or country policy.
If we leave the yearly discount rate unknown, we can
solve (iterate) for the discount rate, which is the
projects ROR, or it is the discount rate which yields a
zero present value.

RM
Extras Chapter 2.2
 What Discount Rate Should and Shouldnt be Used?

Use a rate that is equal to the cost of

capital
Dont use:
Inflation rate
Any added rates, since you cant add
discount rates or any rate of interest
mathematically
All considerations such as risk, inflation, or interest paid internal by
the company should be within the yearly cash flow calculation.

RM
Extras Chapter 2.3
 What is Inflation?

Is a persistent increase of the costs of goods and

services that is not accompanied by an offsetting rise
in productivity, generally refers to a tendency for all
prices in an economy to rise.
In most countries it is derived by an index of a
weighted average prices of a basket of goods, but is
separate from devaluation of that countries currency.
It is linked to money supply, government spending,
and unemployment in a country, i.e. these are drivers
which measure no productivity improvements for the
supply and demand for money in the market place.
Be careful of its use in PV, ROR, DROI calculations.

RM
Extras Chapter 2.4
 Inflation Rate Since 1913 USA
25
20
15
10
5
0
1900 1920 1940 1960 1980 2000 2020
-5
-10
-15
Year

Inflation Rate
RM
Extras Chapter 2.5
 CPI Indexed to 1913 $ USA
250

200

150

100

50

0
1900 1920 1940 1960 1980 2000 2020
Year

Annual Avg
RM
Extras Chapter 2.6
 What is Escalation?

Escalation is also a persistent rise in the price of

specific commodities, like oil price over the past six
years and the recent 85 % increase in one year.
However, it is due to a combination of:
Inflation
Supply and Demand interactions
Can be driven by real or imagined fears that supply
or the commodity is limited.
Escalation and Inflation, must be accounted for in
economic evaluations and comparisons of future
investment alternatives.

RM
Extras Chapter 2.7
 Oil Prices in Two Ways
120

100

80
Price of Oil ($)

60

40

20

0
1860 1880 1900 1920 1940 1960 1980 2000
Year

$ money of the day $ 2006

RM
Extras Chapter 2.8
 Approaches to Time Value of Money

There are two approaches which give

identical decisions, when comparing
alternatives, and have to do with how costs
and revenue streams are handled, they are:
in currency of the day or escalated or inflated or
nominal currency
Using constant purchasing power currency or
deflated or real or constant currency values

You cannot mix the approaches, if done rigorously they

will both give the same result; normally the approach
used is currency of the day.
RM
Extras Chapter 2.9
 When is Discounted Cash Flow Return on
Investment (DROI) used?

Based on after tax cash flow with

project starting in time 0
Usually used with projects with reserve
additions
Utilizes your companies guidelines on
price

RM
Extras Chapter 2.10
 Process for Currency of the Day

We start at time 0 by estimating project costs and

revenues in todays prices, this tells us what the
project would cost if it occurred right now.
It cannot occur right now so we escalate each
component of cost and revenue by its individual
escalation factor.
Annually we calculate the (Net Cash Flow) NCF, as
shown for each component subtracting or adding
from NCF.
Each years cash flow must be brought back to the
present with a discount factor chosen, as PV (Present
Value).

RM
Extras Chapter 2.11
 Other Definitions

Overhead Costs:
Usually defined office costs above
production foreman and plant manager
level in the field
Usually some percentage of the operating
costs, but the way it is done varies by
company

RM
Extras Chapter 2.12
 Other Definitions

Lifting Costs:
Usually defined costs to get oil and gas to
the surface
Defined in various companies/countries as:
Per well per month
Per bbl/ton/m3 per month
Per month

RM
Extras Chapter 2.13
 Finding Costs and Reserve Additions

Cost of Reserve Additions: The Capital spending

associated with projects intending to add reserves of
oil and gas divided by company net oil or gas
equivalent reserves added (Includes acquisitions and
transfers of reserves from PUD to PD, but not
revisions).
Finding and Development Costs: Numerator includes
all capital (Exploration and subsequent Development)
and the Denominator includes reserves and
subsequent additions, revisions, or extensions of
reserves associated with the initial discovery. It is
usually more meaningful if it is looked at over 3-5
year period. Probable and Potential reserves
recognized in the time period can be included as well,
but this should be noted clearly.

RM
Extras Chapter 2.14