class: center, middle, inverse, title-slide .title[ # ECON 366: Energy Economics ] .subtitle[ ## Topic 2.4: Oil and Gas Project Valuation ] .author[ ### Andrew Leach, Professor of Economics and Law ] .date[ ###
aleach@ualberta.ca
leachandrew
@andrew_leach
] --- <!--[test link](weekly_jan_18.html#featured-chart)--> # Net Present Value and other project finance metrics Recall the idea of a net present value of a stream of profits `\(\Pi_t\)` for `\(n\)` time periods indexed by `\(t\)`: `$$NPV=\sum_{t=1}^n \frac{1}{(1+r)^t}\Pi_t$$` This concept forms the basis of a number of important measures used to evaluate projects: - `\(NPV_k\)`, the net present value at a k% rate of discount e.g. `\(NPV_{10}\)` - *payback* is the number of periods `\(n\)` it takes for `\(NPV_0\)` to be positive (i.e `\(r=0\)`) - *discounted payback* is the number of periods `\(n\)` it takes for `\(NPV_k>0\)` for `\(k>0\)` - (i.e for some `\(r>0\)`, usually 10%) - *internal rate of return* (IRR) is the rate `\(k\)` such that `\(NPV_k\)` = 0 - *supply cost* or *break even oil price* is the price at which `\(NPV_k=0\)`, usually reported for `\(NPV_{10}=0\)` --- # Net Present Value and other project finance metrics Recall the idea of a net present value of a stream of profits `\(\Pi_t\)` for `\(n\)` time periods indexed by `\(t\)`: `$$NPV=\sum_{t=1}^n \frac{1}{(1+r)^t}\Pi_t$$` - Why might an oil company use *payback* or *discounted payback as a metric? - Does *break even* mean what you think it means? - Which metric would you prefer? --- # Net Present Value and other project finance metrics Recall the idea of a net present value of a stream of profits `\(\Pi_t\)` for `\(n\)` time periods indexed by `\(t\)`: `$$NPV=\sum_{t=1}^n \frac{1}{(1+r)^t}\Pi_t$$` This deck looks at the last modification to that formula: the *supply cost* for an oil project. - *supply cost* or *break even oil price* is the price at which `\(NPV_k=0\)`, usually reported for `\(NPV_{10}=0\)` --- # Supply Cost Let `\(p\)` be the price of oil - `\(p\)` is usually a benchmark, WTI or Brent - `\(p\)` could also be implied plant-gate bitumen prices, for example Now, allow the stream of profits to be a function of prices `\(p\)` for each time t, denoted by `\(\Pi_t(p_t)\)`, and let the supply cost be given by: `$$\text{Supply cost}=\{\bar{p_t}\}^n_{t=1} \ni \sum_{t=1}^n \frac{1}{(1+r)^t}\Pi_t(\bar{p_t})=0$$` i.e. `\(\{\bar{p_t}\}^n_{t=1}\)` is the set of constant *real* (or, increasing nominal) oil prices chosen such that the net present value of the project is zero, usually for `\(r=10%\)` or `\(r=12%\)` --- # Oil Sands Project Economics What does an oil sands investment involve? - Purchase a lease - Seek regulatory approval - Build an extraction facility - Burn diesel and/or natural gas - Use chemicals - Produce bitumen - Purchase diluent - Ship and sell diluted bitumen - Reclaim/remediate land and tailings --- # Oil Sands Project Economics What does an oil sands investment involve for our purposes today? - Build an extraction facility - Burn diesel and/or natural gas - Use chemicals - Produce bitumen - Purchase diluent - Ship and sell diluted bitumen A simplified version of the problem --- # The basic approach to a financial model What do I need to know to assess the NPV (or other metrics) for this project? - Construction costs and schedules - Operating and maintenance costs - Output - Prices - Fiscal regimes (taxes and royalties) - Financing Initially, let’s worry about the big ones - Prices - Output - Capital, operating and maintenance --- # What am I selling? - Oilsands projects produce bitumen (not a homogeneous commodity, but we’ll treat it as such for today) - In order to be transported by pipeline, bitumen must be diluted - Diluted bitumen trades roughly on par with heavy oil - Heavy oil trades at a discount to light oil due to its lower value to refiners --- # Recall this graph of oil sands pricing? <img src="cdn_bitumen_net_short.png" width="800px" style="display: block; margin: auto;" /> Now we need to solve for the top of the yellow: the implied value of bitumen at the plant gate --- # Derived value of bitumen How much is a barrel of bitumen worth? - Start with the price of a barrel of WCS at Hardisty – $US 56, or $CA 75 per barrel - Now, what do I need to do to get bitumen from my site to Hardisty in WCS-form? - A barrel of WCS is (approximately) 30% diluent, 70% bitumen - I need to purchase .3 barrels of diluent at Hardisty, for a price of $110/bbl, or $33 diluent cost - I need to ship that to my site, at a cost of $1/bbl, or $0.30 total cost - I need to ship one barrel of WCS-equivalent to Hardisty, at a cost of $1.50 - My net revenue from the sale of a barrel of WCS equivalent is (75-33-0.30-1.50)=40.20 What's the implied value of a barrel of bitumen at site? $$\frac{\$75-\$33-\$0.30-\$1.50}{0.7\text{ bbl bitumen}}=\frac{\$40.20}{0.7 \text{ bbl bitumen}}=\frac{\$57.43}{\text{bbl bitumen}}$$ --- # Pricing in the model template <img src="model_prices.png" width="1200px" style="display: block; margin: auto;" /> --- # Sproule Prices <img src="sproule.png" width="850px" style="display: block; margin: auto;" /> You can access the latest Sproule forecast [here](https://sproule.com/wp-content/uploads/2024/01/2023-12-Escalated-2.xlsx). --- # Sproule Prices <img src="prices_in.png" width="1200px" style="display: block; margin: auto;" /> --- # Production - Production timelines will vary by facility, resource type, production technology, etc. - Production drives the revenue side of your cash flow model - Oil sands facilities tend to have a long ramp-up (3-4 years for mines, 1-2 years for in-situ) followed by stable production at or close to nameplate capacity for 25-50 years depending on the facility --- # Production <img src="kirby.png" width="800px" style="display: block; margin: auto;" /> --- # Production and revenue in the model template <img src="production.png" width="1200px" style="display: block; margin: auto;" /> --- # Initial capital and construction costs (including land) Expressed in cost *per flowing barrel*: `$$\frac{\text{Project capital up-front capital cost (dollars)}}{\text{Project daily production capacity (barrels per day)}}$$` > For example: Firebag 4 total cost was $1.7 billion for 42,500 b/d of capacity = $40,000 per *flowing barrel* Think of the oil production from a facility as an annuity, and the cost *per flowing barrel* as the up-front payment to access that annuity for a term equal to the project life. --- # Capital cost inflation was once a major risk <img src="inflation.png" width="800px" style="display: block; margin: auto;" /> --- # Project operating costs and fiscal policies <img src="royalty_data.png" width="600px" style="display: block; margin: auto;" /> You can access the data [here](https://open.alberta.ca/opendata/alberta-oil-sands-royalty-data1) and some background on oil sands royalties [here](https://www.alberta.ca/royalty-oil-sands.aspx). The [historical data](https://www.alberta.ca/historical-royalty-revenue-data.aspx) and the [Alberta Revenue Workbook](https://open.alberta.ca/dataset/382b7a1e-9c34-47c7-9531-38e67ca5441d/resource/370f9030-2d9d-48de-8f81-6e9addabd4b4/download/energy_royalty_revenue_workbook.xlsx) are going to be used in upcoming data exercises. --- # Mining Production <img src="oil_proj_files/figure-html/mines prod-1.png" style="display: block; margin: auto;" /> # In Situ Production <img src="oil_proj_files/figure-html/in situ prod-1.png" style="display: block; margin: auto;" /> # Mining Revenue per Barrel <img src="oil_proj_files/figure-html/mines rev-1.png" style="display: block; margin: auto;" /> --- # In Situ Revenue Per Barrel <img src="oil_proj_files/figure-html/in situ rev-1.png" style="display: block; margin: auto;" /> --- # Sustaining capital costs - Ongoing investment for maintenance of large facilities, including pipelines, well-pads, etc. - Sustaining capital cost captures large expenditures, so does not include all maintenance - Typical values are between $10-12/bbl produced for SAGD facilities, and $6-8 per barrel produced for mining operations --- # Operating costs - Traditionally separated into gas and non-gas operating costs - Natural gas is the single largest component for SAGD facilities. - Some cost figures will also report labour costs as separate components of operating and sustaining capital expenditures - Highly variable at the facility level - SAGD facilities tend to be in the $5-15/bbl range - Mining facilities have increased significantly, to $25-30/bbl (bitumen) ranges, with $40-50/bbl SCO costs in some years - Kearl, the only mine to not upgrade bitumen, had reported operating costs at $36-40/bbl, those decreased by about $10/bbl when the next phase came online - Fort Hills is...well not good --- # Mining Operating Costs <img src="oil_proj_files/figure-html/mining op costs-1.png" style="display: block; margin: auto;" /> --- # In Situ Operating Costs <img src="oil_proj_files/figure-html/in situ op costs-1.png" style="display: block; margin: auto;" /> --- # Fiscal policies - Oil sands were, for a long time, the most interesting royalty issue in the province - Historically, oil sands operations were marginal projects - Significant dependence on the price of oil - Role for government to encourage investment to create jobs, stimulate the economy - *Generic oil sands royalty regime* imposed royalty rates at a fixed 1% of gross revenues until the project costs had been recovered, 25% of net revenues afterwards - 2008 regime introduced a sliding scale for both the base rate and the post-payout rate based on prices - Environmental *costs* were recognized as project costs after 2008 - 2015 Royalty Review largely left oil sands royalties unchanged - Long run oil price outlook may make new projects challenging regardless of royalty structure > What makes a *good* royalty regime? --- # Oil Sands Royalties - Base royalty rate of 1% for $55/bbl and below, increasing linearly to 9% for $120/bbl - Post-payout royalty rate of 25% up to $55/bbl, and increasing linearly to 40% for $120/bbl and above Royalties depend on oil prices, but *what* oil price, *when* and *where*? - the WTI (Cushing) price for a given month, expressed in Canadian currency, calculated as the product of: a. the simple average of the WTI prices for the trading days of the preceding month expressed in American currency, and b. the simple average of the daily actual USD/CAD (noon) exchange rates for that month. --- # Net Revenue Calculation What's the net revenue for the purposes of royalty calculations? > The amount by which the project's revenue exceeds allowed costs, minus other net proceeds. Net revenue can never be below zero. > Calculated as Gross Revenue – Operating Costs – Capital Costs – Return Allowance – Other Costs + Other Net Proceeds. Financing costs are exempt from net revenue calculations --- # Payout Calculation How do you know if a project has paid back its initial investment and you're paying a net or a gross revenue royalty? > Project payout occurs when a project’s cumulative revenues first equal or exceed its cumulative costs. Royalties are typically higher in the post-payout phase. **Once a project achieves payout it remains in the post-payout phase**. > Payout calculation assumes unrecovered capital costs are carried at the Government Long Term Bond Rate. Think of a virtual line of credit where all expenses are spent via the line, and all revenues deposits to pay back the line. When the line is *paid off*, the project has reached *payout*. Projects always pay the greater of the calculated net or gross revenue royalty --- # Gross Revenue Royalty <img src="OilSandsRoyaltyRatesGross.png" width="800px" style="display: block; margin: auto;" /> --- # Net Revenue Royalty <img src="oil-sands-royalty-rates-net.png" width="800px" style="display: block; margin: auto;" /> --- # Payment of Royalties - Always has been “in-kind” for conventional, “in cash” for oil sands - Government had not wanted to be in the upgrading/refining business, and so did not accept bitumen in lieu of cash Under the 2008 royalty regime: > “The government intends to have a portion of its royalty share of bitumen in-kind commercially upgraded to higher value products in the province. The government wants to hear from companies interested in buying bitumen from the province for upgrading and other value-added activities in Alberta.” For our purposes, that's not really important, but it does matter for producers. --- # Mining Royalties <img src="oil_proj_files/figure-html/mine royalties-1.png" style="display: block; margin: auto;" /> --- # In Situ Royalties <img src="oil_proj_files/figure-html/in situ royalties-1.png" style="display: block; margin: auto;" /> --- # Mining unrecovered capital costs <img src="oil_proj_files/figure-html/mining cap_cost-1.png" style="display: block; margin: auto;" /> --- # In Situ Unrecovered Capital Costs <img src="oil_proj_files/figure-html/in situ cap_cost-1.png" style="display: block; margin: auto;" /> --- # Mining Operating Profits (Post-Royalty) <img src="oil_proj_files/figure-html/mine net profits-1.png" style="display: block; margin: auto;" /> --- # In Situ Operating Profits <img src="oil_proj_files/figure-html/in situ net profits-1.png" style="display: block; margin: auto;" /> --- # Taxes Main tax policies include - Federal and provincial corporate taxes - Capital cost allowance - CDE and CEE - Other issues affect junior oil and gas companies a lot more than oil sands firms - e.g. flow-through shares and tax losses We won't go into details on corporate taxes, but they are calculated in your model --- # The inutition in the model: commodity prices <img src="sensitivity_oil_gas.png" width="1000px" style="display: block; margin: auto;" /> --- # The inutition in the model: differentials <img src="sensitivity_oil_hld.png" width="1000px" style="display: block; margin: auto;" /> --- # Supply cost basics - the particular project in the model I've given you has a supply cost of about $40/bbl WTI - supply costs will vary (all else equal) with: - heavy oil differential (+, higher diff means higher WTI price needed) - CAD (+, stronger CAD (fewer CAD per USD) means higher WTI price needed) - gas prices (+, higher gas price means higher WTI price needed) - capital costs (+, higher Capital cost means higher WTI price needed) - operating costs (+, higher op costs means higher WTI price needed) - taxes and royalties (+, higher taxes mean higher WTI price needed) --- # Supply Costs in Practice <img src="aer_bitumen.png" width="1000px" style="display: block; margin: auto;" /> --- # Supply Costs in Practice <img src="aer_supply_costs.png" width="1000px" style="display: block; margin: auto;" /> --- # Key concept review - Netback bitumen pricing - Royalty regimes for oil sands and non-oil sands extraction in Alberta