Determining Project Profitability (includes associated papers 17025, 17085, 17128 and 17139 )

Abstract

Distinguished Author Series articles are general, descriptiverepresentations that summarize the state of the art in an area of technology bydescribing recent developments for readers who are not specialists in thetopics discussed. Written by individuals recognized as experts in the area, these articles provide key references to more definitive work and presentspecific details only to illustrate the technology. Purpose: to informthe general readership of recent advances in various areas of petroleumengineering. Summary. Project profitability analyses determine the impact of investmentson the investor's financial position. An investment screening criterion willidentify acceptable investment opportunities, which will enable the investor toundertake those projects that will provide the greatest increase in networth. Introduction To remain in business, it is necessary to invest primarily in projects thatare expected to generate funds in excess of the investment over a period oftime-i.e.. show a profit. This was qualified by the word "primarily," becausefrom time to time it is necessary to undertake certain projects that are notexpected to show an obvious profit, but must be undertaken anyway for othercompelling reasons, such as safety, environmental, or legal. This paper willnot address these investments but will focus solely on investments made withthe expectation of a profit. This paper will be further limited to a discussionof profitability determination for investments to be made in oilfield-typeprojects. Obviously, not all investments made with a profit motivation will actuallyresult in a profit, because there are many unforeseen occurrences that cansubstantially reduce or even eliminate the anticipated income. The importantfact in making an evaluation before the expenditure, however, is that a profitis expected. The term "expected" will be used throughout to indicate astatistical outcome. Expected values for the particular evaluation reflect notonly what is most likely to happen, but also the best and worst outcome thatcould reasonably occur. Procedures used to evaluate the profit potential of investments have notalways been as detailed as those used today. Before the widespread use ofsophisticated calculators and computers, many rules of thumb were used in placeof more rigorous calculations. Such guidelines as limiting investment to agiven number of dollars per barrel of daily production, or a certain multipleof the annual income, or a specified dollar value for each barrel of oil in theground were widely used. Profit per barrel of reserves was commonly calculatedwith current costs and revenues. But as more rigorous methods were developed toevaluate investment opportunities, along with tools to make those calculationsquickly and accurately, such techniques have become widely used and accepted bythe petroleum industry. Undiscounted profit and undiscounted profit-to-investment ratio werecriteria used for many years to judge the desirability of investmentopportunities. While this obviously was an improvement over simple rules ofthumb, it ignored a very significant factortime-and its associated cost, thecost of the invested funds or what is usually called interest. Interest can bethought of as rent that must be paid to use the money and is a cost of doingbusiness as much as direct operating costs. This is obviously true whenborrowed funds are used, but is just as true when funds from any other sourceare used, because if they were not invested in the project being considered, they could earn interest elsewhere. The underiving principle in most investmentevaluation techniques in use today recognizes the time value of money, which isapplied by discounting future cash flows to present value at some particulardate. This gives meaning to the phrase "time is money." Purpose of Economic Analyses The purpose of an economic analysis is to determine the effect a certaininvestment will have on an individual's or company's financial position. Because the objective is to evaluate only the change of financial position thatwill result from a potential investment and not to determine the overallprofitability of the organization, the investment opportunity can be evaluatedalone. JPT P. 263^