The option traders workbook a problem solving approach pdf

Content of PetroWiki is intended for personal use only and to supplement, not replace, engineering judgment. SPE disclaims any and all liability for your use of such content. ISBN Get permission for reuse. Gross production is one of the most important numbers entering the net cash flow calculation and, simultaneously, one of the most difficult to determine accurately.

Much of the science and art of petroleum engineering is involved in estimating these numbers for future time periods. In the model defined in Fig.

Usually the decline curves that are used to forecast future revenues are based on production rather than sales. If there is significant shrinkage, that should be taken into account before calculating the cash flows.

Typical causes of shrinkage include lease use of gas for heater treaters or compressor fuel. If shrinkage is negligible, gross sales will equal gross production. Typically, the people who drill and operate a well do not own the minerals they are extracting. For example, the U. Government, state governments, Indian tribes, or private citizens usually own minerals in the United States.

In most other countries, the state usually owns the minerals. The producers lease the right to develop the minerals from the mineral owners.

This leads to various kinds of interests in the property. Working interest is a share of the costs. The total of all the working interests in a well must be equal to one. Along with the share of the costs comes a reduced usually share of the revenue. Working interest may also change over time as a result of "oil field deals. As deals become more and more complex, it becomes very difficult to determine ownership. One method of answering the "who, what, when" question is discussed in Thompson and Wright [1].

Royalty is a share of the revenue free and clear of all costs of development and production. The royalty is paid to the owner of the mineral interest under the land associated with the well. In the United States, the mineral interest can be "severed" from the surface ownership so that the person who owns the surface may not have any interest in the minerals and may not receive any income from a well.

In rare cases the owners of the working interest will own the minerals and, in that case, there is no royalty. Typical royalty rates in the U. Overriding royalty is the same as a royalty, except it does not come about because of ownership of the mineral interest. An "override" is a classic way for a lease broker or geologist to be compensated for buying leases or putting a deal together. For net revenue interest, the working interest owners pay all of the costs.

The share of the gross production from the well is referred to as "net revenue interest. Net sales is the product of gross sales and net revenue interest.

It is your share of the production after accounting for shrinkage, royalties, and splitting the proceeds with other working interest owners. This tax may range from 3 to This tax is often referred to as an ad valorem tax from the Latin for "according to value. The method of calculating assessed value varies considerably from state to state. The two most common methods of calculating assessed value are to use some fraction of the revenue received and to use some fraction of the calculated net present value of the projected production.

In most cases, each party pays their own severance and ad valorem taxes. In other words, the working interest owners only pay state and local taxes on their share of the production, and the royalty owners pay the tax on their share of the production. In countries other than the U. In most cases there are numerous other taxes that may need to be taken into account such as road taxes, airport taxes, or stamp duties.

The oil company usually attempts to negotiate an agreement that exempts them from all these taxes in return for a royalty or a share of the production. These negotiations are sometimes successful and sometimes not.

Operating costs are those costs that are necessary to maintain production from the well. Offshore wells can have even higher operating costs. Another component of operating costs is the Council of Petroleum Accountants Societies COPAS or fixed-rate overhead charge. These discussions frequently have resulted in the creation of guideline documents and educational materials.

You can find these materials in the Products section of this site. COPAS has grown to 23 local Societies and over 2, members in the United States and Canada. Operating costs in other countries can vary dramatically. In most cases the operating costs will include facilities to house expatriate workers and their dependents as well as other normal operating expenses. Depending on the situation, these costs can be very significant in the cash flow calculations.

Sometimes called "cash generated from operations" or other names, net operating income is the cash flow to the working interest owner after operating costs and state and local taxes have been paid, but before investments have been made. This represents the cash generated during the period that is available for investment. Almost all federal governments including the United States Government and most state governments levy a tax on income.

The calculation of these taxes can be fairly straightforward in countries such as Indonesia or extremely difficult, especially when a single project is being evaluated for a reasonably large company in the U. Even when the appropriate software is available to aid in the evaluation, the input data necessary to accurately calculate income tax is often hard to obtain. For this reason and because income tax often has a relatively low impact on the final decision, it is common practice to calculate before federal income tax BFIT net cash flows when evaluating U.

Major oil companies are more likely to attempt to include the effects of income tax in their calculations, while independents seldom include it. The effect of using BFIT numbers on the ultimate decision is highly dependent on the individual case, but experience indicates that in the U. Investments are costs that benefit future periods as opposed to operating costs that only benefit the current period. Examples include buying a lease, drilling a well, buying and installing a pumping unit, and building tank batteries.

In all of these cases, the goods purchased are expected to help produce money far into the future. Net cash flow is the amount of money that flows into or out of the treasury during any one period.

It is equal to the net operating income either before or after income taxes less the investments. Each of these items is estimated for every future time period until the net operating income is no longer positive.

At that time the well s is are usually assumed to be plugged and abandoned. There may be an additional expense at that time for abandonment costs, or the salvage value of the equipment may be equal to or greater than the abandonment costs.

Money has a time value.

This means a dollar received today has more value to us than a dollar received far in the future. Other than a desire for instant gratification, there is a very rational reason for this phenomenon. If we have a dollar today, we can put it to work by making an investment and have more than a dollar at some future date. This concept of putting the money to work has important implications later in this section when discount rates are discussed. Another important concept is the concept of equivalence between a current lump sum of money and a lump sum to be received in the future.

No matter what the amount of money necessary to tip the scales, the concept that money has a time value is established. We are often faced with the choice of having a certain sum of money now or receiving various sums of money in the future. By determining the equivalence between money received today and money received in the future, we can make an informed decision. In the previous example, making the choice is relatively simple. There are only two sums to compare, and the time period is one year.

The mechanism that works best is interest. We can define interest as the amount of money that must be added to our current sum to make an equivalent future sum. The amount of interest necessary to create equivalence is dependent upon the period under consideration.

To easily compare all three alternatives, interest is compared as a rate. It may be expressed as The interest rate is calculated by dividing the amount of interest paid per period by the principal amount at the beginning of the period. For loans or bank deposits that exceed one year, the interest is usually compounded. That is, the interest earned during the first period is added to the original principal to form the principal for the second period.

The compound interest concept will be used when calculating the equivalence between a sum of money today and future sums of money. If we have a present sum of money, Pand we put it to work at a compound interest rate, iwe will have a future lump sum of money, Fat the end of n periods.

The relationship between these parameters is expressed in equation form as How much money will be in the account after five periods? Present worth of lump sum is by far the most important equation in discussing the time value of money. This one equation allows the creation of an equivalence between future projected net cash flows and current sums of money, which can then be compared to the amount to be invested to obtain those net cash flows.

If an amount, Fis going to be received n periods in the future, then its present value, Pcan be calculated for a given interest rate, iby rearranging Eq. The justification for this formula lies in the equivalence concept. The sums P and F are equivalent to each other because P could be invested at i for n periods to become F. Although there are some theoretical difficulties, it is quite practical to use a value of 2. This technique is used quite often when calculating the present value of annual cash flow streams.

When cash flows are calculated for several periods, as done in Fig. There are a number of specialized equations that can be used when particular types of repetitive cash flows are projected. In particular, when the same cash flow, Ais received at the end of every period, the present value of the cash flow stream can be calculated from the equation, It is also used to calculate loan payments where P is the principal amount.

See Thompson and Wright, [1] Chap. The effective-monthly-rate method, although more complicated to calculate, has some advantages as discussed later in Sec.

In this method, the annual interest rate is converted to a monthly rate, which, when compounded 12 times, results in the annual interest rate. Rearranging this equation gives When the purpose of an economic analysis is to help make a decision, there are several key managerial indicators or economic parameters that are considered.

Although there are many parameters that can be considered see Thompson and Wright, [1] Chap. Each of these criteria is discussed next. Net present value is the sum of the individual monthly or yearly net cash flows after they have been discounted with Eq. In this table, the NPV were calculated on a monthly basis using effective-monthly interest rates converted from annual rates with Eq. After the discounting method has been specified, there is still the question of what discount rate to use.

The average investment opportunity rate is the interest rate that represents, on average, the return of the future investment opportunities available to the company. This is the rate at which the treasury will grow. An alternative interest rate is the weighted average cost of capital WACC. This is an interest rate that, as the name indicates, is the average of the cost of each source of financing weighted by the fraction of the total financing that source represents.

Sources of financing include debt, which has an explicit interest rate associated with it, and equity, which has an implicit bux.to cashout paypal associated with attracting and retaining investors.

The average investment opportunity rate and the weighted stock options deduction cra cost of capital are often very similar to each other and often much lower than the typical "hurdle rates" used in the industry.

The use of high discount rates to account for risk is not recommended. Much has been written about the fallacy of using high discount rates see, for example, Capen [6]. Later sections of this chapter deal with decisions under uncertainty.

The decision criterion using net present value is very simple. For project screening, all projects with a positive NPV at the company average investment opportunity rate are acceptable. If the projects with a positive NPV perform as projected, they will return more to the treasury than the average company project will return.

In the case of mutually exclusive alternatives, where choosing one alternative precludes choosing another, the alternative with the highest NPV should be chosen. An example of mutually exclusive alternatives might be choosing between injecting CO 2 or high- pressure air as a secondary recovery method—only one or the other may be chosen, not both. Discounted profit-to-investment ratio has been touted by R.

Seba [9] as "the only investment selection criterion you will ever need," in his paper of the same name. This paper and the various discussions of it present a good discussion of the method.

Mechanically, profit-to-investment ratio is calculated by dividing the sum of either the net operating income or the net cash flow from a project by the sum of the investments. If undiscounted numbers are used, the result is an undiscounted profit-to-investment ratio; if discounted numbers are used, the result is a discounted profit-to-investment ratio.

If net operating income is used in the numerator, a value of 1. If net cash flow is used in the numerator, a value of 0. Either definition is appropriate for the numerator, as long as it is clearly stated which definition has been used. Discounted profit-to-investment ratio at the company average investment opportunity rate is indeed a powerful selection and ranking tool, as stated by Seba. As a selection tool, all projects with a value greater than 1.

In the presence of limited capital, the projects are ranked in decreasing order of discounted profit-to-investment ratio and selected until the capital available for investment is exhausted.

This very simple tool results in the portfolio of projects that causes the treasury to grow at the fastest rate, if the projects perform as expected. The example in Table More than 70 different people have calculated the simple problem shown in Table Phase One consisted of 30 runs with different programs during the s.

In Phase Two, the problem was run by 12 vendors of commercially available economic evaluation software in late and early Phase Three included runs by various oil company and vendor personnel during late and early In each phase, the problem statement was identical, except for the effective and production dates, which were always January 1 and February 1, respectively, of the year when the case was run.

The problem is an evaluation of a drilling prospect assuming a single "time 0" investment, exponential decline, and escalating prices and costs. The problem was originally designed to be solved by hand, so it has a five-year life.

There was a surprising diversity in the reported answers. In fact, the problem was solved 74 different times, which resulted in 68 different answers. More details are available in Wright and Thompson. The results of that study indicated that there was a great need for standardization and communication regarding upstream economic calculation.

To begin that communication process, the SPEE formed quests that make money runescape to draft recommended evaluation practices.

Ten of those recommended evaluation practices were approved by the members attending the annual meeting of SPEE in June and are in the process of being approved by the SPEE membership as a whole.

These recommended engineering practices REP address issues such as the elements of a report REP 1 and how to discount cash flows REP 5. The REPs are available the option traders workbook a problem solving approach pdf the SPEE website, which is SPEE. The SPEE REPs are not intended to be required practices but are suggested ways to present the the option traders workbook a problem solving approach pdf when you do not have compelling reasons to do otherwise.

REP 5 on discounting is of particular interest in the context of this chapter. It is recommended that end-month discounting be used for calculations using monthly cash flows and that mid-year discounting be used for calculations using yearly cash flows. Additionally, it is recommended that the effective monthly interest rate, as defined by Eq.

When monthly cash flows are discounted using the effective monthly interest rate, the results are very similar to that obtained by discounting annual numbers using mid-year discounting. In the previous discussions, we assumed to know the model parameters with certainty. This is free turtle trading strategy not the case, so some method of handling uncertainty is appropriate.

There have been a number of textbooks written on the subject, but one of the best is Decision Analysis for Petroleum Explorationoriginally written in by Paul Newendorp and updated in by Newendorp and John Schuyler. The following discussion briefly covers some of the topics contained in their book. This is both the curse and the attraction of the industry. Great fortunes can be made or squandered on the basis of a single decision.

Some authors use the terms "risk" and "uncertainty" interchangeably, and some authors make a great distinction between them. We shall use the term uncertainty to express the concept that we do not know the outcome of a decision when we make it. We shall use the term risk to mean that in any decision we make, there is a possibility of an fx options ubs outcome—losing money in the context of this chapter.

Further, we will assume rational decision making. The practice of "risk analysis" or "decision analysis" is a way to analyze the potential privatization political risk and stock market development of decisions objectively and consistently.

Risk analysis does not eliminate dry holes or even bankruptcy, but applied properly it helps keep you in the game. One of the most important aspects of "playing the game" is to try to make sure you are in a winning game.

Risk analysis can provide the information to keep you from playing a known losing game, such as being on the wrong side of the roulette wheel in a gambling casino, but it may not help you much if you are unknowingly playing a losing game while thinking you have a chance of winning. Judgment and luck still count. Monte Carlo Simulation is a calculation technique that uses distributions earn money doing java projects uncertain input variables rather than single point estimates.

It results in a distribution of potential outcomes with associated probabilities and has a number of advantages:. One of the more important numbers is the mean or expected value of the distribution. We can make a decision with this number alone, just as we have done with EMV and decision trees. However, much more information is available, such as the probability of the project losing money assuming EMV was calculated in the simulation and the chances of the project making a large amount of money.

Ideally, the entire cumulative frequency graph should be presented and compared with other projects, so the decision maker can see the full spectrum of anticipated possibilities. There are a number of good references on Monte Carlo simulation, including a paper by Murtha [19] and the text by Newendorp make money high alching runescape Schuyler Chap.

Another excellent reference is Chap. VI, Emerging and Peripheral Technologies. There are two methods of advanced decision analysis that are slowly making their way into the petroleum project evaluation process. One of these is known as portfolio analysis, and the other is the real options analysis. The portfolio analysis quantifies the effect of interactions between projects, and the real options analysis attempts to value the fact that a company has several options in developing projects, such as the ability to abandon a project early or defer a decision to make an investment until the financial climate is more beneficial.

Portfolio analysis is based on the Nobel Prize-winning work of Harry Markowitz in the early s [20] [21] in which he showed that the variance in results from a portfolio of stocks could be reduced by choosing stocks with a negative correlation. If two stocks are correlated negatively, when one stock is down the scalping strategy for binary options combo method stock will be up, and the portfolio will grow with very few wild swings.

This concept has been introduced into the petroleum literature by several authors [22] [23] [24] [25] [26] [27] [28] [29] [30] with some modifications. The following paragraphs from Brashear, Becker, and Faulder [23] give an overview of the methodology.

Superscripts denoting the references have been added by the current author. If these points are done, along with educating the managers, real options could become a useful tool. Join SPE Log in About Help. Petroleum Engineering Handbook Larry W. Volume I — General Engineering. CopyrightSociety of Petroleum Engineers.

Chapter 16 — Petroleum Economics. Wright, SPE, Norwest Questa Engineering Corp. Normally, only very large acquisitions are evaluated by examining the impact of the acquisition on the financial net income. The tax model is used only if an after-tax analysis is done.

Cash flows for the project are forecast for each year or each month until the well or project is no longer economical. Because of the ready availability of powerful computers, evaluations are usually done on a monthly basis, and the results are reported on an annual basis. Monthly calculations are more detailed but not necessarily more accurate. There is often a tendency to consider more detailed calculations as being more accurate. The use of finer time increments does not necessarily lead to projections that are more in conformity with truth.

Whether the calculations are done on a monthly or yearly basis, the same process is followed. The profit for each period is defined as net cash flow and, for a Royalty-Tax system such as that used in the U. A sample calculation is shown in Table The values in this table were calculated monthly and then accumulated on an annual basis. Time Value of Money Money has a time value.

Future Worth of a Lump Sum If we how to buy share of freehold a present sum of money, Pand we put it to work at a compound interest rate, iwe will have a future lump sum of money, Fat the end of n periods. Present Worth of Lump Sum Present worth of lump sum is by far the most important equation in discussing the time value of money. Annuities and Loans There are a number of specialized equations that can be used when particular types of repetitive cash flows are projected.

Monthly Interest Rates Interest rates are normally expressed on an annual basis or per annum. As the previous equations show, when working with monthly cash flows, it is necessary to convert the annual interest rate to a monthly interest rate. There are two ways to do this: These two methods will result in different answers.

Consumer lending groups use the divide-by method to comply with the Truth-in-Lending Act. The Truth-in-Lending Act required disclosures from lenders, which include, among other things, the note interest rate, any points or origination costs, and most lender imposed fees, such as underwriting and processing fees.

These fees are all rolled into the calculation of an annual percentage rate APR for the loan. As the name implies, this is an annual rate. Because most consumer loans are paid on a monthly basis, the monthly rate, used in Eq. The next example illustrates the calculation. Key Economic Parameters When the purpose of an economic analysis is to help make a decision, there are several key managerial indicators or economic parameters that are considered.

Net Present Value Net present value is the sum of the individual monthly or yearly net cash flows after they have been discounted with Eq. Internal Rate of Return Internal rate of return IRR has been a popular managerial indicator since the s, and it is still widely used today.

IRR is defined as that interest rate which, when used in the calculation of NPV, causes the NPV to be zero. Notice that, once again, we are using the effective monthly interest rate and, therefore, must use Eq. IRR can easily be used to screen projects.

If the IRR is greater than the average investment opportunity rate, the project passes the screen. However, the unwary might be trapped in a situation where two mutually exclusive projects are being compared.

Many evaluators have a tendency to think that the project with the larger IRR is the better project. This is not necessarily so. If IRR is used to compare two mutually exclusive projects, it is necessary to calculate the IRR on the incremental capital used for the project with the larger investment. Although this can lead to the correct decision, the procedure is tedious enough that it is easier to just compare NPVs at the average investment opportunity rate. Choosing the project with the higher NPV, at the average investment opportunity rate, leads to the same decision as calculating incremental IRR.

Under certain circumstances there may be more than one interest rate that will cause the NPV to be zero.

This is referred to as multiple rates of return and occurs primarily in the evaluation of acceleration projects. As stated by Phillips, [7] an acceleration project is "one in which money is invested, not necessarily to show a profit but to decrease the time required to obtain the income from a project. In fact, acceleration projects will generally result in a net loss.

In this hypothetical case, virtually the same amount of gas is expected to be produced over a shorter time period, yet there is a large investment to drill the additional wells. When the infill project is evaluated on an incremental basis, the cash flow stream is negative then positive and then negative again, as shown in Table On an undiscounted basis, the project loses money. The only justification for doing the project in this hypothetical case is to "accelerate" the cash flows, so the company can invest them elsewhere.

Recommended Practices for Economic Calculations More than 70 different people have calculated the simple problem shown in Table Risk Analysis for Oil and Gas Property Evaluation In the previous discussions, we assumed to know the model parameters with certainty. Expected Monetary Value Concept Expected monetary value EMV is the foundation of risk analysis as described in this chapter.

Newendorp and Schuyler [5] page 82 state that "the expected value concept is more nearly a strategy, or philosophy for consistent decision making than an absolute measure of profitability. Numerically, expected value is the return on average given repeated trials. That is, over the long haul, we would obtain an average result equal to the expected value.

When making a decision, each alternative has an expected value associated with it. Having made a decision, there are a number of potential outcomes. The expected value of a decision alternative is obtained by summing the product of the probability of occurrence of a potential outcome and the payoff for each potential outcome.

This is done for each decision alternative, and we then choose the one with the highest expected monetary value. As an example, assume you have prospects to drill: All numbers are net present values at the company average opportunity investment rate and, therefore, include the costs to drill and produce the oil.

The costs include additional development wells. This is certainly a winning game. That analysis is beyond the purview of this chapter but is a topic under the category of "decisions to purchase imperfect information.

Let us use expected value to investigate the drilling of one well. Out of possible wells, ten will result in field discoveries. We can analyze this example in a table such as Table This is the same value we calculated on average assuming we drilled all prospects. So what happens if our model truly represents nature and we drill the well?

In fact, that will happen nine times out of ten on average. This is where the repeated trials and consistent application previously mentioned come in.

If we apply the same methodology a large number of times, the odds are in our favor, and we will prevail. We expect the odds to catch up with us somewhere around 30 trials. The Next Frontier There are two methods of advanced decision analysis that are slowly making their way into the petroleum project evaluation process. Portfolio Analysis Portfolio analysis is based on the Nobel Prize-winning work of Harry Markowitz in the early s [20] [21] in which he showed that the variance in results from a portfolio of stocks could be reduced by choosing stocks with a negative correlation.

Harry Markowitz [21] demonstrated in the stock market that risk and return are usually correlated. Achieving higher yields generally necessitates taking greater risks. Further, he pointed out the risk-reducing effects of diversification were reduced if multiple investments are positively correlated but amplified if the investments are negatively correlated.

He posited that a rational investor would seek the mix of investments portfolios for which no other combination would have a higher return without increased risk or lower risk without loss of return. He coined the phrase "efficient frontier" for the set of portfolios that meets these conditions.

David Hertz [25] extended these concepts from investments in financial assets to investments in "real" assets. An efficient frontier could be composed of capital projects that reflected both economic value and risk measured by standard deviation. This idea was later proposed also by Hightower and David [28] and Edwards and Hewitt [29] and updated by Howell et al. The method is conceptually simple but computationally complex. The algorithm is a mathematical programming solution that evaluates all combinations of investments that yield a specific "target" expected value to define the one combination portfolio with the lowest risk at a given capital constraint.

Other constraints can be added. The process is repeated for all other specific target values, each time finding the specific portfolio with the lowest risk.

The locus of the minimum-risk points, the efficient frontier, is the set of all portfolios that satisfies the criterion that no increase in value is possible given the constraints without greater risk and no reduction in risk is possible without loss in value.

Other algorithms find the maximum value at each risk level; either way the result is the same. In some references, the axes are reversed. Reward is often represented by expected monetary value EMVwhile risk has several possible definitions. Markowitz used variance of the expected portfolio return as a metric for risk or its square root, standard deviation. The petroleum industry is more concerned about downside risk, so oftentimes, semistandard deviation the downside or mean loss is used as a measure of risk.

Whatever the metrics, the objective is to select a portfolio of projects that maximizes reward for an acceptable level of risk. A quantitative example is used to demonstrate the methodology. Light Sweet Crude Oil, http: An Overview of Ad Valorem Taxes.

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