Chapter 2 Petroleum Economics – Evaluation Methods

*Define an asset

Assets are an item of value that provide positive value to an owner. They can be tangible objects such as land or equipment or intangible such as intellectual property.

*List different types of assets


The most important source of value to a petroleum company comes from the rights to mineral resources.


These can range from a single item to complete processing facilities.


A project has an end goal and specific objectives. It is an identifiable activity with associated costs and benefits.


A legal entity which can have intrinsic value due to branding.

Financial Investment

Investments in financial products such as bonds, CFDs, futures contracts, shares, options, derivatives etc.


Intellectual property.

Human Resources

Human resources team.

*Identify and explain the three important valuation concepts

Book Value Method

Book value method derives a valuation by looking at the financial history of the asset and its current valuation to arrive at a value for the company.

Market Value Method

Market value method reflects the current perceptions of the company and assets in a forward looking context. Market value is market capitalization (probably).

Cash Flow Method

Cash Flow derives a value based on the believed future earnings of the asset in terms of revenue and cost.

*List several business situations where evaluation is required

  • Mergers and Acquisitions
  • Purchase or Hire of Equipment
  • Development of an oil or gas field
  • Negotiating to borrow towards an investment
  • Reporting to Shareholders
  • Tax Assessment

*Define the concepts of depreciation and book value

Depreciating is the process of adjusting the value of an asset downwards over time, adjusting to account for its true value.

Book value method derives a valuation by looking at the financial history of the asset and its current valuation to arrive at a value for the company. Book value has some limitations and problems:

  • Inappropriate deprecation
  • Price inflation
  • Worthless assets
  • Value without cost

*Calculate depreciation using the following methods: Straight Line, Declining Balance, Units of Production

See photo

*List applications of the book value method

Book Value accounting method is used throughout preparation of company accounts and annual reports. It may also be used in assessment of tax liability. Companies are usually limited by law in what they can and cannot do with the method. Book Value has some limitations:

  • Value without cost
  • Worthless assets
  • Price inflation
  • Inappropriate depreciation

*Explain the impact of inflation on the book value method

Inflation causes value to rise. During periods of high inflation accounts needed to consider inflation accounting procedures because the rate of inflation may have been greater than the reduction in value due to depreciation. This meant that there was a net increase in value year on year. This is usually only the case with extremely high inflation rates.

*Explain the book valuation of exploration drilling and subsurface reserves


*List the factors which contribute to the quality of a market valuation

The following areas contribute to the quality of a market valuation:

Asset Definition

We need to be able to compare like with like in order to make a valid comparison and determine a realistic value.

Transaction Statistics

Transactional Statistics have the advantage of averaging out values when compared to asset definition which may take a single value and could be subject to unusually circumstances.

Market Knowledge

The market price is said to reflect all knowledge both public and private. The market price is comprised of supply, demand and market structure and competition.

*Describe and explain the structure and behaviour of a simple market model

Simple market model has price and quantity axes with an upward sloping linear function representing S1 (primary supply function) and a downward sloping linear function D1 (primary demand function). The lines intersect at P*Q* which is the market equilibrium price and quantity.

*Explain the behaviour of the market for mobile drilling rigs

We’ll run through a quick play-by-play of the market dynamics.

Consider a market is initially in equilibrium and then the oil price increases. Because of this increase oil companies now forecast better returns from discoveries and plan to drill more exploration wells. Cash flow increases and demand for drilling rigs increases (the line shifts to the right). The price to lease rigs increases correspondingly, rig operators earn higher profits, so rig operators bring more rigs to the market in the same way the oil company drilled more wells. Rig operators build more rigs, the rig supply then increases (shifts to the right) and the rig-easing rate declines.

*Define cash flow and incremental cash flow

There is nothing in the notes about incremental cash flow.

Cash flow is

*List and explain the characteristics of a cash flow

Money exchanging ownership. Cash flow methods concern the future impact of an asset on the performance of a company. Cash flow have currency units, a sign (positive or negative), timing (the specific date of transfer of money).

*List different types of cash flow, differentiate between capex and opex

Capex creates assets whereas Opex is written off.


Stands for Operational Expenditure. It is the cost of keeping a production and operating system running. The amount is quoted as an annual cost and can include the following:

  • Facilities rental
  • Platform operation, maintenance and transportation costs
  • Export costs including tariff payments, operation of tankers, pipelines or terminals
  • Workover operations on wells
  • Insurance and administration


Stands for Capital Expenditure and covers several stages relating to the investment in new physical assets or upgrades to existing assets. Capex covers the following areas:

  • Exploration – geophysics, drilling and geology
  • Appraisal – Geology, geophysics, drilling and well-testing
  • Field Development – Drilling, production wells, support structures, production facilities and export facilities
  • Field Modifications – Additional wells, injection facilities, artificial lift, gas compression
  • Abandonment – Seal off wells, removal of facilities

Field development is the most capital intensive process.

Cash Flow Models

  • Sales Revenue
  • Capex
  • Opex
  • Taxes
  • Net Cash Flow

*Describe the general nature of the cash flow associated with a project

Projects have a large number of individual purchases and sales which be almost negligible to incredibly expensive. Project cash flows can typically be categorized under either positive cash flows (revenue) or negative cash flows (Capex, Opex and Taxation).

We can characterize cash flows according to what stage the well is in its life.

Build Up

Build up is the stage from beginning to the peak of production.

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