Knowing When to Quit: Timing Petroleum Field Abandonment Decisions to Optimize Net Present Value

Summary:

Presented is a simple, transparent and mathematically sound approach to calculating the ELT (economic limit test) by considering all actual investor cash inflows and outflows (including abandonment costs) and the time value of money. This method - in contrast to common industry practice, including PRMS guidelines promulgated by the SPE et.al --permits (to the extent that any forecast model can) timing the abandonment decision to maximize investor NPV (Net Present Value). If the aim of investment activity is to maximize value to the Investor, then the time to end the activity is when the Investor believes maximum possible value is achieved, before value is destroyed by continuing. To prevent such value destruction, upstream petroleum industry investments usually have some form of economic limit test (ELT) which determines that it is time to stop a project when forecasted “value” (i.e. some definition of revenue minus some definition of costs) would otherwise turn permanently negative. While this is appropriate, the authors believe that industry participants commonly use ELTs which are flawed, because they are based on the wrong measure of value. Although the industry does generally agree that the point of investment is to maximize value, specifically post-tax Net Present Value (NPV) of future Net Cash flow (NCF) – i.e., all revenue received by the Investor, less all costs incurred by the Investor, discounted using an appropriate discount rate – in practice, commonly used ELT calculations erroneously measure something else.

Scope:

This report presents – both in the article and in several Microsoft Excel models -- a simple, transparent and mathematically sound approach to calculating the Economic Test Limit (ELT) in a way calibrated to maximize Investor Net Present Value (NPV). It does so with comparative, parallel calculations based on what the authors believe to be the common, but flawed industry approach, which ends up maximizing not Investor NPV, but rather a variant of cashflow which is less meaningful, as it excludes certain Investor costs. One such set of excluded costs are abandonment costs, which, using the common industry approach, can be difficult to include in the ELT calculation as it can lead to mathematical circularities. Other such excluded costs include income taxes, the time value of money, and in some cases, revenue “lost” to governments under Production Sharing Contracts (PSCs). The authors contend that since Investors do in fact consider all these items when calculating NPV, then they should also consider them calculating the ELT, and thus when to schedule abandonment. In other words, if maximizing Investor NPV is the point of investing, then both the valuation and ELT calculations should focus on the same thing. The article and models show how to base the ELT on NPV maximization while avoiding circular calculations, and provide several fiscally detailed and plausible models showing how the authors’ approach can result in materially higher NPV than the common industry approach. Included are: