Accounting and Economics in Oil and Gas - Question 1

According to the case study regarding restoring a well to production, the initial investment for completing the entire restoration is $750,000. The table below shows the expected STB per year (units of stock tank barrels or barrels) produced expected revenues, expenses taxes and net cash flows for a period of seven years.

Year

Production STB/year

Revenue Cash Flows $000

Expenses $000

Taxes $000

Investments $000

Net Cash Flow $000

0

       

750

-750

1

48,800

976

233

297

 

446

2

48,700

974

233

296

 

445

3

39,000

780

206

230

 

344

4

29,300

586

170

166

 

250

5

19,500

390

143

99

 

148

6

9,800

198

107

36

 

55

7

4,900

98

38

24

 

36

Total

2,00,000

4,002

1,130

1,148

 

974

  1. The Total Profit = Sum of Net Cash Flows - Total Investment
  • Sum of Net Cash flows (in 000’s) = $ (446 + 445 + 344 + 250 + 148 + 55 + 36)
    1. =$ 1,724
  • Total Investment (in 000’s) = $750
  • Total Profit ( in 000’s) = $1,724 - $750= $974

Another way of calculating total profit is:

  • Total Profit = Total investment + Total Revenues - Total Expenses - Total Taxes
    1. Total Investment (in 000’s) = $750
    2. Revenues = $4,002
    3. Expenses = $1,130
    4. Taxes = $1,148
  • Total Profit ( in 000’s) = $750 + $4,002 - $1,130 - $1,148 = $974
  1. Pay-out Time refers to the time frame within which the business will reach break-even point (no profit-no loss). Also known as the Payback period, it can be calculated using the following formula(Payback period – Meaning, Usage & Illustrations, 2020)
    1. Payback Period/ Pay-out Time = Initial Investment / Average Cash flows after Tax
    2. Initial Investment (in $000’s) = $750
    3. Average Cash Flow after Tax = Sum of Net Cash Flows / Duration of the projects
    4. Average Cash Flow after tax ( in 000’s) = $ 1,724 / 7 = $246.29
    5. Payback Period/ Pay-out Time = 750 / 246.29 = 3 years
  2. Cost of Discovery and Development of Reserves refers to the total profits or reserves discovered as a proportion of the expenses incurred in discovering these reserves. Using the Full Cost Method of accounting the cost of discovery and development of reserves can be determined by dividing the total expenses by total production. (Livernois, 1988)Therefore,
  • Total units of STB produced in 7 years = 200000
  • Total Cost Incurred in producing this quantity = $1130 + $1148 = $2278
  • Cost of Discovery and Development of Reserves = 200000 / 2278 = $ 87.80 per unit.

Accounting and Economics in Oil and Gas - Question 2

The initial cost of undertaking any of the four projects by Pipson Oil and Gas Company is given as $2,000,000. Due to capital shortage, the company can utilize this investment across any of the four projects, whose details are listed below on a yearly basis, for the next 5 years:

Cash Flows

Project A ($)

Project B ($)

Project C ($)

Project D ($)

Year One

5,00,000

6,00,000

10,00,000

3,00,000

Year Two

5,00,000

6,00,000

8,00,000

5,00,000

Year Three

5,00,000

6,00,000

6,00,000

7,00,000

Year Four

5,00,000

6,00,000

4,00,000

9,00,000

Year Five

5,00,000

6,00,000

2,00,000

11,00,000

Discount Rate

6%

9%

15%

22%

Pipson Oil and Gas Company can select the most viable project basis two of the most widely used capital budgeting methods; Net Present Value (NPV) and Internal Rate of Return or IRR. The higher the Net Present Value or the Internal Rate of Return for a project, the more viable it is. NPV help in examining the viability of the project based on the time value of money. It helps in estimating the present value of future revenues by discounting them at a certain rate during the lifetime of the project. It is the most widely used and recommended capital budgeting methods. (Hart, 2020)The Internal Rate of Return is calculated by the following formula theoretically. It is a trial and error method that requires two components namely, present value of future cash flows and the initial investment. It signifies the discount rate at which the net present value will be zero. Thus, using the Excel function of =IRR(values,[guess]). The IRR determine the discount rate at which the company is expected to reach break-even. If the IRR of the calculated project is more than the present discount rate, the project is viable. The table below shows the NPV and IRR calculated using excel based formulae for each of the four projects. (Internal Rate of Return (IRR), n.d.)NPV can also be calculated using the following formula - Net Present Value = Sum of Present Value of Future Cash Flows After Tax - Initial Investment but in this case we have chosen the excel formula of determining the NPV i.e., =NPV(rate,value1,[value2],…).

NPV Calculation

Project

Year One

Year Two

Year Three

Year Four

Year Five

Discount Rate

Net Present Value

Project A ($)

5,00,000

5,00,000

5,00,000

5,00,000

5,00,000

6%

21,06,182

Project B ($)

6,00,000

6,00,000

6,00,000

6,00,000

6,00,000

9%

23,33,791

Project C ($)

10,00,000

8,00,000

6,00,000

4,00,000

2,00,000

15%

21,97,127

Project D ($)

3,00,000

5,00,000

7,00,000

9,00,000

11,00,000

22%

17,80,586

IRR Calculation

Project

Initial Investment

Year One

Year Two

Year Three

Year Four

Year Five

IRR

Project A ($)

(20,00,000)

5,00,000

5,00,000

5,00,000

5,00,000

5,00,000

8%

Project B ($)

(20,00,000)

6,00,000

6,00,000

6,00,000

6,00,000

6,00,000

15%

Project C ($)

(20,00,000)

10,00,000

8,00,000

6,00,000

4,00,000

2,00,000

20%

Project D ($)

(20,00,000)

3,00,000

5,00,000

7,00,000

9,00,000

11,00,000

18%

According to the NPV method, while all projects are viable as they have a positive NPV, the most profitable project is Project B with a net present value of $23,33,791. A positive NPV indicates that the project returns are greater than its investments which are the case with all the four projects. However, Project B provides the highest returns compared to other four. According to the IRR method, if the IRR is greater than the discount rate, the project is viable. In all the above cases, the IRR is the highest for Project C, however if we look at NPV and IRR combined, Project B looks a more viable option for the investors. Generally when evaluating projects, the priority of selection is based on NPV and other capital budgeting methods such as IRR, Profitability Index and Payback period are used to further support that decision. Here, IRR of 15% which is greater than the discount rate of 9% for project B, makes it the most viable option for Pipson Oil and Gas Company.(Hart, 2020)

Accounting and Economics in Oil and Gas - Question 3

a) The Cash Flow Statement of a company provides an understanding of the way liquid is utilization by that company, through its operating, investing and financing activities. It is the third most important financial statement of a firm, after the Profit and Loss Statement and the Balance Sheet. The net cash increase or decrease from the cash flow statement is reflected in the balance sheet. For example, for any business to become sustainable it must have enough cash funds at any given point, during the year. A cash flow statement depicts the cash position of the company. In the statement given above, a net decrease of $12,000 indicates that the company has exhausted all its cash funds from operating and financing activities, in its investing activities such as the purchase of land, building and equipment. For a company to remain solvent, it must have cash at all times to pay its expenses, dues and even unforeseen liabilities. A cash deficit can often render a company insolvent or bankrupt as in the cash of the statement given above. The company has exhausted all its net income of $134,000, operating income of $60,000 and income from financing activities of $132,000 in buying land, building and equipment of $338,000.

It shows a lack of planning on part of the firm that has caused an overspending of $12,000. Thus, when we analyze the cash flow statement of a company, financially, we develop an understanding of the profitability of that company, along with how they have efficiently utilized their operational cash flows. It talks about the firm’s revenue situation and its potential of backing the company through liquid assets. For example, a payment of prepaid expense shows the company’s ability to dispose cash for future period in the current year. However, since the net cash flow is negative it indicates that the business is losing money despite making a profit of $134,000. This reflects poor management of available cash reserves for clearing business expenses. It also reflects inefficiency of time, in managing income and expenses on the part of the company. The company cannot bring cash into the business again easily, in case of a negative cash flow. The goal then shifts to ensuring business sustainability as it makes it increasingly difficult for the business to expand.(Pristine, 2017)

b) Conducting a comparative analysis of a company’s cash flow statements provides an understanding of the earning capacity, risks and cash liquidity of the business. They help the business in measuring the recurring potential of the firm’s investors (funding sources), the costs associated with obtaining these investors and the future reliability of these sources. Furthermore, a comparative analysis helps in showcasing the competitive position of the firm along with the growth prospects using these funds. Comparative analysis of cash flow statements provides a universal and comprehensive overview of the firm’s present and future financial position. It aids in the planning of monetary requirements with respect to future projects. Data thus obtained, enables the financial analysts and CFO of a firm to recognize factors that are atypical or recurring in nature along with changes in cash flow from each of the three activities defined in the cash flow statement.

It also aids in predicting the future return on investments on the firm’s assets such as plant and machinery, based on their depreciation. The firm can also estimate its growth probability, based on requirements of cash such as focusing on particular sources of funding and methods in which future payments can be done, whether the company has enough cash to meet its liabilities and pay dividends to shareholders. It helps the company in evaluating the kind and extent of financial activities required to amplify non-current assets and to strengthen operations. The financial analysts of the firm can obtain the cash flow per share (Net Increase/Decrease in cash divided by the total number of shares) to understand the liquidity status of the firm. The higher the ratio, the more the liquidity is of the firm. (Pristine, 2017)

c) When it comes analyzing the managerial activities that can be facilitated by cash flow statement, the firm needs to understand the importance of two aspects; profitability and present and forecasted cash flows. The board or management team of the company is accountable for designing the process of cash flow management. This means, they need to plan the ways and timings to manage the cash assets of the company. Managerial skills are required in scenarios where the expenses for certain activities, estimated for the year exceed the expected revenues for those set of activities. In such cases, the managers can decide to procure a loan or equity financing or sell a few of its long-term assets or a business vertical. They can also, prioritize the activities basis their cash funds by making changes in the execution plan. For example - putting a cap over the marketing budget or holding up acquisitions for the current year. Another way of handling this situation is deciding to modify expenditures planned. For example: the company can decrease its dividend payments to the shareholders or payments to its investors.

Irrespective of the above suggestions, the main role of the manager is to maintain a balance between the current and long-term availability of cash basis the needs and requirements. Evaluation or assessment of the cash flow statement helps in supporting managerial plans such as maintaining coordination between policies related to dividends with other commercial activities, allocation of budgets for new product development and assets required by the firm, consolidating the cash position and cash availability and estimating the viability of all the managerial plans and approaches related to business growth. The proportion of net cash flows from investing activities and those from financial activities, indicate the overall cash required by the company for its investments needs, by accumulating funds through public financing. (Putra, n.d.)

The questions a manager must consider while understanding the cash flow statement are whether these funding obtained from investors will be sufficient enough to meeting the investment requirements. Consequently, the proportion of net cash flows from investing activities to that from operating activities indicate the amount of funds required from the sale of products and services the firm specializes in to meet its investment needs. This financial analysis enables the finance heads and board of firms to evaluate the cash position of the firm along with a roadmap for the future. Insufficient cash funds as seen in the cash flow statement above, poses critical implications because it results in reducing profitability, higher financial risk and even liquidation of the firm.(Putra, n.d.)

d)Investing activities in a cash flow statement reflect the investments (long term or short term) undertaken by the firm during that financial year. These mainly refer to acquisitions, buying of plant and machinery or other types of non-current assets, sale of business segments or depreciated assets, etc. An assessment of the investing activities of a firm indicates the investments made by the company in other companies for the purpose of expansion or diversification. It might help the analyst understand the future direction of the company and the changes in the goals and philosophies thereof. When one analyses an increase in the long-term assets such as purchase of plant and machinery, it is generally indicative of expansion measure undertaken by the firm. It helps the business head in identifying the types of assets purchased and the risks associated with it.

For example, these assets are purchased for a project that might be financially risky and have multiple aims and goals. This helps provide an insight into the risk potential and expected returns. The type of asset purchased indicated the future road map and income potential of present and newer product lines, business segments and verticals. It helps the finance team analyze the financial viability of these assets. Through investing activities, the business heads can also determine if there are possible contractions in business indicates by sale of long-term assets or business segments without them being appropriately replaced. Lastly while understanding business challenges through these activities, the firm can evaluate its position by understanding if the problems are because they are internal or due to external or industry related scenarios.(Bragg, 2018)

Accounting and Economics in Oil and Gas - Question 4

Petroleum Economics requires the usage of economic analysis skills and techniques at each and every step during the lifecycle of oil and gas discovery and manufacturing projects. There are a variety of factors that impact the economics of such projects. These are:

  • The extent of expertise and knowledge in this sector
  • The quantity, nature and location of wells to be explored
  • Market situations
  • The tax and royalty rates and structure

Petroleum economics runs the entire hydrocarbons industry. Every single decision made is based on its economic assessment. Economic assessments are done to identify the reserves and the ‘standardized measure of value’ for the objective of reporting for entities that are held by the government. In multiple scenarios, the objective of a business is to arrive at decisions that have the best opportunity in terms of exploiting profits. Having mentioned that a company’s major objective is to earn profits, it finds it best to define the term profit in the following three ways each having its individual set of observations and assumptions that deliver a different approach and output. The three methods or models of determining profits in the hydrocarbon industry using petroleum economics are (i) net cash flow model, (ii) financial net income model and (iii) tax model.

Generally defined, profits earned during a periods refers to the net earnings of the firm after accommodating for all the expenses incurred during that period. In the hydrocarbon industry this period is generally defined within the range one month to one year. Therefore, the value of income earned during a period is same for all the above three methods, and is defined as yearly, in general cases. There could be a difference in timing when it comes to recognizing revenues, but these differences are comparatively negligible. The basic difference in the above three models is the timing of the expenses. These expenses can be further divided into costs, which are of value only during the present year. The first model - cash flow model makes the assumption that hundred percent of the investments and expenditures are identified as and when they occur. The next model of financial net income assumes that revenues should be associated with their respective costs incurred to earn that revenue. This ensures all costs are recorded in the present period, while investments are recognized in the long run. The overall expenditure over the project’s life is equal in case of both these models, but the ratio of expenses allocated during each period might differ significantly.

Different types of deprecation methods might be included by the accountants to match the costs incurred while generating their respective revenues. There are two depreciation methods followed in the hydrocarbon industry; (i) units of production and (ii) straight line method.

Under the units of production method, the total production of the period is divided by the total volume that is required for production. The result obtained is then multiplied by the total amount made in that investment. Thus, this causes the investments being apportioned using the dollar per barrel basis. Under the straight-line method of depreciation, the investments are apportioned using the dollar per unit time basis.

By evaluating all of the above factors, Petroleum Economists can help in ascertaining decisions related to investments. These include drilling wells for oil exploration, prioritising the timelines of the projects and its profitability and viability. They are important in the discussions and arbitrations regarding Production Sharing Contracts and buying of oil and gas properties. Petroleum Economists are also required to conduct the evaluation and supervising of the technological, financial and other uncertainties related to the different parts of an oil or gas projects. It enables Petroleum Engineers who are building their expertise in petroleum economics to work for oil and gas exploration and production companies, service companies, banks and investment houses and government agencies.(School of Minerals and Energy Resources Engineering, n.d.)

References for Accounting and Economics in Oil and Gas

Internal Rate of Return (IRR). (n.d.). Retrieved from My Accounting Course: https://www.myaccountingcourse.com/financial-ratios/internal-rate-return-irr

Putra, L. D. (n.d.). Analysis Of The Statement Of Cash Flows [With Case Examples]. Retrieved from Accounting Financial Tax: http://accounting-financial-tax.com/2008/09/analysis-of-the-statement-of-cash-flows-with-case-examples/#:~:text=Managerial%20planning%20is%20aided%20when,and%20ascertaining%20the%20feasibility%20and

School of Minerals and Energy Resources Engineering. (n.d.). Retrieved from University of New South Whales: https://www.engineering.unsw.edu.au/minerals-energy-resources/what-we-do/what-do-mining-engineers-do-what-do-petroleum-engineers-do/petroleum-economics#:~:text=They%20are%20crucial%20in%20the,an%20oil%20or%20gas%20projects.

 Livernois, J. R. (1988, May). Estimates of Marginal Discovery Costs for Oil and Gas. JSTOR, Vol. 21,(No. 2), 379 - 381.

Pristine, E. (2017, July 15). Cash Flow Statement. Retrieved from EduPristene: https://www.edupristine.com/blog/cash-flow-statement-in-detail

Bragg, S. (2018, December 12). Cash flows from investing activities. Retrieved from AccountingTools: https://www.accountingtools.com/articles/what-are-cash-flows-from-investing-activities.html

Hart, M. (2020, February 9). Net Present Value (NPV), Explained in 400 Words or Less. Retrieved from HubSpot: https://blog.hubspot.com/sales/net-present-value

Payback period – Meaning, Usage & Illustrations. (2020, June 05). Retrieved from Clear Tax: https://cleartax.in/s/payback-period

School of Minerals and Energy Resources Engineering. (n.d.). Retrieved from University of New South Whales

Remember, at the center of any academic work, lies clarity and evidence. Should you need further assistance, do look up to our Economics Assignment Help

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