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First of all we have to understand the
Classification of Petroleum Products
The petroleum products that may be subject to evaluation can be grouped
as:
crude oil - natural gas - associated products
Crude oil is a liquid composite of many
hydrocarbon compounds that, depending on
the composition, has differing
properties such as oil gravity,
viscosity, and pour point which, at
least in part, define the quality of the
oil for end use and also influence the
methods that would be used to develop
and produce the oil. Crude that has a
high API gravity and low viscosity is
generally easier to produce than low
gravity, high viscosity oil that may
require stimulation to maintain
production rates. The characteristics of
the oil can, and often does, influence
everything from well spacing to pump
size to life of production-all of which
has an impact on the economic value of
the producing property.
Crude oil is a market commodity and is
subject to considerable variation in its
economic value. Oil price varies based
on location, gravity, sulfur content and
competition from other fuel sources. As
an example, crude oil produced in
California is consistently priced
$3-4/bbl below similar oil in the mid
continent in part because of oil gravity
but also because of the sulfur content
and the lack of access to other markets.
At times, such as under the WPT,
crude oil has been economically
stratified based on when it was put on
production and the status of the
producing company.
Natural gas is a fluid also composed of
many hydrocarbon compounds although
generally not as complex as crude oil.
The primary differences between gases
are:
(1) the heating value (generally the methane content).
(2) the non-hydrocarbon gas (N2, 0,, HpS, etc.) content.
(3) the amount of liquid or heavy ends that can be obtained as natural gas
liquids (NGL).
The economic value of natural gas is
directly related to its composition. A
gas with no non hydrocarbons and which
is entirely methane and ethane has a
high heating value. If it contains
propanes and other strippable ends, the
value increases. Natural gas enjoys a
relatively high economic value because
it has a low cost of production.
However, it is highly regulated through
pipeline and utility controls on
transportation and pricing so that it
rarely achieves equivalent value with
crude oil on a $/Btu basis. In addition,
due to the ease of transporting gas,
there is substantial competition among
gas producing regions, which acts as a
control on gas prices.
Associated products include (a) natural
gas liquids (NGL) that can include
propane, butane, natural gasoline and
virtually any other hydrocarbon that can
be stripped from gas, (b) sulfur, (c)
non hydrocarbon gases. The NGLs can have
substantial economic value but require
investment in specialized striping
plants.
Pricing tends to be driven by the local
market and can be volatile with demand.
Sulfur is a common by-product in many
Canadian fields and in some areas of the
United States. The economic value tends
to fluctuate considerably, and sulfur
production may often be more of a
nuisance than an economic benefit. Non
hydrocarbon gases such as nitrogen and
helium can be economic by-products, but
in most cases where this occurs the non
hydrocarbon becomes the primary product
and the natural gas is secondary.
The economics of crude oil, natural gas
and associated products can differ
significantly depending on market
conditions.
Petroleum
Market
Petroleum-oil, gas and derivatives-are
the primary sources of energy in the
world today. There are other major fuel
sources, such as coal and nuclear power,
but petroleum remains the major source
in the United States, Europe and Japan.
These markets together account for about
45% of world energy usage and petroleum
provides over 60% of energy in these
areas. Petroleum is likely to retain
this position because there are very
large volumes of oil and gas already
discovered and available at relatively
low prices. The combined reserves of the
Persian Gulf states alone are sufficient
to supply current world demand for
50-100 years. Moreover, these reserves
can be produced at low cost when
compared to production in the United
States and other parts of the world.
Persian Gulf reserves are large enough
and production sufficiently controlled,
even though somewhat erratically, by the
Gulf countries, that the increase in
usage of higher-cost energy sources such
as nuclear or environmentally acceptable
coal would be very difficult unless
heavily subsidized.
In the United States and other areas
where similar industry conditions exist,
petroleum economics will be controlled,
indirectly and directly, for the
foreseeable future by the baseline oil
price either set by or derived by major
producing countries. Under market
conditions, oil priced in the United
States cannot rise much above the world
market level but can readily fall below
that level. Production in the United
States is generally in decline so that
the United States, along with Europe and
Japan, is a net importer of over 50% of
crude oil demand, thereby tying the
United States market more closely to
world markets. In addition, United
States production is very high cost
relative to the Persian Gulf or anywhere
else so that the difference between
price (revenue) and cost of production
can be, and often is, very narrow. As
shown by the events of 1985-1986, a
decrease in oil price is often enough to
render a large volume of U.S. production
uneconomic, causing wells to be shut in
and abandoned; resulting in the
cancellation or deferment of new
drilling, exploration and other capital
investment projects; and bringing about
the financial collapse of oil companies,
service companies, and whole regions
that depend on the oil industry.
The primary impact of the market for
petroleum is, of course, on price.
Throughout history, prices for oil and
natural gas have varied with demand and
supply. In the United States, there have
been periods of high production relative
to demand causing prices to drop; as
well as periods of high demand relative
to production that resulted in price
increases. For a long period, however,
from the early 1930s until 1971, oil
production was controlled by proration
that limited production, particularly in
Texas but also in other areas, to a
certain “allowable” each month that was
expected to fulfill, but not exceed,
demand. The allowable production was set
as a percentage of productive capacity.
This regulation resulted in stable and
relatively low oil prices for most of
that period.
The increase in allowables over time to
100% in the early 1970s was one of the
major reasons that control of the world
market passed from the United States to
OPEC and from industry to governments in
the mid-1970s. The U.S. economy is,
among other things, energy intensive. In
this situation, changes in oil and gas
prices take on national significance and
can have immediate and serious impacts
on the economy of regions and the
country as a whole. The demonstration of
this is in the relation between oil
price and inflation. Since 1928, the
first year that reliable inflation data
in the form of the Consumer Price Index
was kept, changes in oil price can be
shown to be closely followed by changes
in CPI or, more broadly, inflation.
Major price increases such as 1971-1973
and 1979-1980 resulted in serious
increases in inflation in those and
following years. For most of the period
from 1928 to 1994, however, oil
production exceeded demand. Price was
regulated through proration and in many
years oil price declined. Inflation,
however, being caused by many factors,
continued even though at low rates so
that, while the nominal or actual oil
price may have increased slightly or
remained essentially constant, the
“real” price-the nominal price minus
inflation-actually declined for many
years and has, in fact, declined
significantly since 1982.
Preparation of a Cash Flow
A cash flow consists of five basic
elements: (1) production schedule, (2)
product prices, (3) ownership interests,
(4) costs of production and (5) capital
investments.
The cash flow can be expanded in any of
these segments and through the addition
of income tax considerations. The cash
flow is designed to model the
production, price and cost expectations
of the evaluator to an economic limit. A
production schedule must be estimated
for oil and gas production plus any
associated production such as NGL or
condensate. Previous discussion has
described the methods of estimating
future reserves and production.
Extrapolation of existing or similar
property production decline is the most
direct method of estimating future
production when either oil or
nonassociated gas is the primary
production stream. Associated gas may be
projected as a function of oil
production using a fixed or variable
gas-oil ratio (GOR). Nonassociated gas
may have associated condensate
production that can be projected as a
fixed or variable yield.
Where decline curve extrapdation is
used, the form of the decline, whether
exponential, hyperbolic or harmonic,
must be defined and applied. It is
always a good idea to compare the
reserves obtained from production
decline with reserves obtained from
other methods such as ratexum or WOR-cum
curves or to volumetric and/or material
balance calculations. When decline curve
extrapolation may not be appropriate,
such as when projecting future
production from a new field or reservoir
or for an EOR project, production
estimates can be obtained by converting
the volume results of the material
balance, frontal advance, or other
method into annual or monthly
production. This may require determining
a limiting condition that can be
identified, such as lifting capacity or
injection rates and back-calculating a
production rate. However it is done,
be sure to compare the production
schedule with other similar projects or
fields and with good reservoir and
operating practice. Also, the selection
of a schedule may have economic impacts,
such as the requirement for investment,
increased operating costs, or in some
circumstances royalties and/or taxes
that may cause an alteration of the
selected production schedule. Finally,
as noted earlier, the proper analysis of
the source and form of the production
data is very important to a valid cash
flow analysis.
Product prices are the market price of
oil, gas, condensate, or NGL. A cash
flow is usually done as of a point in
time so the prices would be those in
effect at that date. Two basic sources
for product prices are actual sales and
posted prices. The actual price for oil
and/or gas being received on the
property to be evaluated is the best
source of a price for a cash flow. In
using actual prices, determine if there
are any shipping, pipeline, dehydration
or other deductions that would reduce
the price actually received for the oil
or gas produced. These charges must be
accounted for in the cash flow. Also,
gas sales prices are often based on the
heating or Btu value of the gas not on
the Mcf or volume of gas.
Since gas production is normally
expressed in Mcf, a correction must be
made if the gas price is in $/Btu.
Posted prices (Figure 7-10) are the
prices offered in the market by large
purchasers of crude oil, such as major
refiners. The appropriate price for the
oil in the property being evaluated can
be estimated by obtaining one or more
posted prices for oil of a similar
gravity in or near the same field and
making necessary adjustments for
gravity. Gas prices can be estimated
from standard prices offered by
pipelines in the area. Gas sales are not
always as straightforward as oil sales.
During periods of high demand, the
purchaser may be willing to take all the
gas that can be produced and will build
the connection lines to the property. At
other times, however, the purchaser may
limit sales to a percent of capacity and
may not be willing to provide
connection. These conditions could not
only reduce revenue from sales but could
require additional investment and may
have the effect of reducing production
of other products if the gas is
associated gas. Whatever the conditions,
they must be considered in the
production schedule and cash flow.
Condensate is generally treated and
priced as crude oil. NGL is generally
treated as a by-product of gas sales
where “wet” gas containing NGL is sold
to a “gas plant” that strips out the
liquids and sells the “dry” gas and
liquids. The producer may receive
revenue from the dry gas sales and a
share of NGL sales or he or she may
receive a wet gas price.
The projection of product prices into
the future depends on the perspective of
the evaluator regarding future economic
conditions and, to some extent, the
purpose of the cash flow. The simplest
approach is to determine the appropriate
price(s) as of the date of evaluation
and hold those prices constant for the
life of production. This was virtually
the only way projections were done prior
to the price increases of the 1970s and
is still relatively common. Constant
pricing is required for SEC evaluations.
Since the 1970s it has become more
common to attempt to estimate whether
oil and/or gas prices would change over
the expected life of production and to
build those anticipated changes into the
cash flow by escalating or deescalating
oil prices at certain rates over time.
The question of whether or not to
escalate prices in a cash flow depends
on the information available to the
evaluator and how well the evaluator can
translate information into expectation.
Major companies often have economics
departments whose purpose is to estimate
future oil prices that are often
implemented in cash flows. Smaller
companies and others are generally
without such resources and must rely on
other, published and unpublished sources
and their own intuition. Since the early
1970s, oil and, to a lesser extent, gas
have been open market commodities
subject to a wide range of forces
causing prices to rise and fall. Most
price projections that extend for more
than a year or two will probably be
wrong except that over time, because oil
and gas are finite resources, the price
must eventually increase. As will be
discussed below, the use of several cash
flows with differing price projections
may serve to reduce
price
risk
The
prices used in cash flow projections are
normally “nominal” prices that include
expected inflation. In making
projections of oil prices, it is
important to keep in mind that the rate
of increase of oil prices, the
escalation rate, has rarely exceeded the
rate of inflation for more than 2-3
years and that, after that time, the
escalation rate may be equal to or less
than the rate of inflation. On average
the “real” price of oil (real = nominal
minus inflation) has increased by an
average of 1.1% over the 60 years from
the late 1920s to the late 1980s,
including the major increases of the
1970s . Most oil field operating costs
are directly influenced by inflation so
that price escalation should not exceed
cost escalation for any extended period
of time.
Fair Market Value.
Many investments, such as purchasing
properties or valuations done for ad
valorem or estate taxes, require a
determination of fair market value as
the goal of valuation. The most common
definition of FMV is:
“The price that would be paid by a
knowledgeable and willing buyer and
which would be accepted by a
knowledgeable and willing seller neither
being under any pressure to conclude a
transaction.”
This definition, in various forms, means
that the real value of a property can
only be established in the marketplace
by the free interaction of buyers and
sellers. The true FMV will only be known
after a property has been sold. However,
it can be (and often must be) estimated
through property valuation. FMV
evaluations require the use of
price/cost projections and DCRs that
reasonably approximate the marketplace
for property sales.
References:
1. Petroleum & Natural Gas Engineering,part.2
2. Petroleum Engineering Handbook |
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