A Short-Cut Method For Determining Present Worth Of Future Income And Rate Of Return On Investments In Oil-Producing Properties

Abstract

Publication Rights Reserved This paper was to be presented at the 40th Annual Fall Meeting of the Society of Petroleum Engineers of AIME, to be held in Denver, Colorado, October 3–6, 1965, and is considered to an abstract of not more than 300 words, with no illustrations, unless the paper is specifically released to the press by the Editor of the Journal of Petroleum Technology or the Executive Secretary. Such abstract elsewhere after publication in the Journal of Petroleum Technology or Society of Petroleum Engineers Journal is granted on request, providing proper credit is given that publication and the original presentation of the paper. Discussion of this paper is invited. Three copies of any discussion should be sent to the Society of Petroleum Engineers office. Such discussion may be presented at the above meeting and, with the paper, may be considered for publication in one of the two SPE magazines. Abstract The procedure described herein provides a simplified solution to the problem of evaluating investments in oil producing properties by the discounted cash flow method. Long year-by-year calculations, trial-and-error solutions for the rate of return on the investment, and "after Federal Income Tax" calculations are eliminated by the short-cut procedure. Computation time for the entire discounted cash flow calculation is thus reduced to about 5 min. where graphic accuracy is acceptable, or to about 20 min. where more precise answers are desirable. The widely accepted assumption of interest compounded annually at mid-year is retained, and the answers are therefore - within certain limits of accuracy - equal to those produced by conventional, "long-hand" calculations. An interrelationship established between the rate of return, payout, and profit-to-investment ratio is shown by the short-cut method to provide a basis for grading investments according to more meaningful, positive terms such as "excellent", "good", "fair", etc. The effect of errors in cost estimates is shown to result, for practical purposes, in the rate-of-return concept's losing its meaning at rates exceeding about 100 per cent/year or in cases where the economic life is less than about three years. Finally, a procedure to replace the "dual" rate-of-return concept is briefly described. While the short-cut procedure is primarily geared toward evaluation of drilling prospects, it can be used in any case wherein the discounted cash flow concept applies, including the case of gas wells. Furthermore, portions of the procedure can be adapted to a wide variety of minor economic problems that heretofore have commonly been neglected due to the long calculation procedure involved. Introduction In recent years, the discounted cash flow method of evaluating investments in oil producing properties has gained wide acceptance in principle. The conventional solution, however, has not been so widely accepted because of the long calculations involved. Most major oil companies have resorted to the use of computers or alternate solutions to accomplish the objectives of the conventional solution.