Question

Prepare a group 10 page report on the evaluation process of an oil and gas asset to your bank for a project finance
loan!!!! The @Risk spreadsheet must be submitted as well!

Answer 1

Exploration and production (E&P) companies often invest in assets outside their home country; in fact, many of these companies have groups specifically dedicated to evaluating overseas investment opportunities. For example, ONGC Videsh, which is the overseas arm of Indian national oil company Oil and Natural Gas Corp. (ONGC), owns participating interests in 38 oil and gas assets in 17 countries. The sole business of ONCG Videsh is to prospect for oil and gas acreages outside of India for exploration, development, and production. Another example comes from Mexico, where the recently concluded shallow-water bid round saw 20 individual companies and 16 consortia from 15 countries bid on 15 shallow-water blocks in the Gulf of Mexico.

The reasons for investment diversification across political borders vary from seeking the highest-quality assets, increasing energy security for the home country, or transferring relevant technologies and skills to hedging geopolitical risks or engaging in diplomacy. The technocommercial evaluation of these assets by investors provides for an exciting work experience for E&P industry professionals. The process is not purely technical or limited to the evaluation of the asset’s production performance. Careful consideration is also given to the business environment, fiscal policy stability, and political stability of the country, among other factors.

Oil and gas companies maintain a balanced portfolio of exploration, development, and production assets, and the proportion of these assets is governed by the company’s overall strategy. Risk-averse companies may prefer to farm into a producing asset and acquire a stake as a nonoperating partner. Companies with exploration experience and risk appetite may bid on government auctions for exploration blocks or farm into exploration assets.

Some companies focus on successful exploration and prefer to make a profitable exit by selling their stake before the development of the asset begins. E&P companies, in general, seek out investments in assets based on their corporate risk profile and production and/or reserve booking and replenishment targets.

Most companies have an asset-screening process for new investments. This is designed to reduce the opportunities to be evaluated to a manageable and practical number. The screening criteria may be a combination of:

1. Technical considerations—based on asset quality and the company’s expertise and experience

2. Financial considerations—based on the amount of investment, expected post-tax returns, cash flow constraints

3. Geopolitical considerations—based on political stability of the region, fiscal regimes, safety considerations

Technical Considerations

The essential technical questions in their simplest form are:

• How much hydrocarbon is present?

• How much hydrocarbon can be economically recovered?

Exploration assets require extensive analysis by geologists, petrophysicists, and geophysicists, with an emphasis on seismic data availability, data quality, and information availability from nearby analogue fields. Development or producing assets are more production-oriented—for these fields, reservoir performance analysis, reservoir modeling, and field development planning are usually more important than seismic interpretation. As the number of wells increases and production histories grow longer, confidence in earth models (geocellular or static models) and reservoir simulation models (dynamic models) increases.

Typically, the seller provides a data package, which can be purchased at a nominal price by interested investors to perform their own analysis. For exploratory blocks the data package generally includes available seismic data, geology reports, well logs, and core reports. For producing assets the data package may contain information on production history, well designs, complete asset models (including both earth and dynamic models), surface facility designs, and evacuation options.

In addition to the expected hydrocarbon volumes, production rates, and drilling schedules, there is also the element of development costs. Estimation of capital expenditure (drilling costs and facilities costs) and operating expenditure influences asset profitability. There are multiple software tools available that use historical, regional cost databases to provide estimates of capital and operating expenditures based on the development plan. It is interesting to note that depending on the phase of the development, these cost estimates can vary by as much as ±40%. During the tendering and procurement stage, for example, the cost estimates are well-defined and stay within a ±5% range. Relevant health, safety, and environment considerations, such as the age and condition of existing infrastructure and the history of safe operations, are also accounted for.

Financial Considerations

Oil and gas assets in the exploration and appraisal stage usually require large investments with a long gestation period, but development assets or producing assets may offer a quicker payout. The investing company must align the magnitude of the investments and the cash flow schedule with its corporate cash flow planning.

Companies often elect to bid as a consortium, with each partner having a varied stake and the largest stakeholder usually operating the assets. Depending on its technical capabilities and presence (or lack thereof) in the region, a company may choose to opt for an operating stake or a nonoperating stake in the consortium.

The project’s profitability is calculated based on the revenue and cost estimates and compared using standard measures such as net present value, internal rate of return, return on investment, and payback period. Due to fluctuations in the price of oil and uncertainty in production profiles, the ability of revenue streams to hit certain predetermined targets is not always guaranteed; depending upon the lease or concession duration, these forecasts may have to be prepared for 10 to 40 years. A longer concession period implies higher uncertainty in revenue and costs. The economic calculations must always be weighed against all technical, financial, and geopolitical risks. (For more details refer to Economic Evaluation of Oil and Gas Projects.)

Geopolitical Considerations

Some regions may have unstable governments, safety risks for employees, risks of pilferage and/or theft, and supply disruptions. The threat may even be political in nature. An abrupt change in fiscal and monetary policy, for example, could change tax rates and impact profitability. Independent rating agencies, including the Global Peace Index, Political Stability Index, and Ease of Doing Business Index, among others, prepare yearly rankings of countries that are useful as screening tools for investors to avoid assets that come with high geopolitical risk.

Countries with higher risk will often, however, offer a better reward; as such, many companies continue investing in high-risk areas to chase high returns. Additionally, a review of the legal structure and tax regime in the country of operation is needed to accurately calculate post-tax profits and other bidding parameters.  

Asset evaluation studies are multifaceted and time-bound, with sellers often having fixed disinvestment timelines and government auctions of blocks always having deadlines. Sometimes the first-mover advantage comes into play when there is no structured bidding timeline defined by the seller. A team of experienced, multidisciplinary experts performs these evaluations rapidly, sometimes in timeframes of weeks rather than months. Specialized software tools and information databases are available for these studies, with some companies outsourcing them to technical, financial, and legal consultants to expedite completion. High-value investments require the best quality of due diligence. Predicting the profitability of multibillion-dollar investments in oil and gas assets, after all, is no easy task.