W20_TRI_ Economic Evaluation on Gas Development Project

1.      Problem recognition, definition and evaluation

Two scenarios of gas development project needs to be analyzed using main economic indicators, i.e. IRR and NPV. The two scenarios are as follows:

- Case 1: Delivering 55 BBTUD sales gas to buyer A and 5 BBTUD to buyer B for about 9 years, then delivering 15 BBTUD to buyer B for next 7 years.

- Case 2: Delivering 60 BBTUD sales gas to buyer B for about 9 years, then delivering 15 BBTUD to buyer B for next 7 years.

The production facilities will be built using EPCI contract with total duration 3 years, including 1 year for tender and budget approval process.

2.      Development of the feasible alternative

The economic model of gas development project using Production Sharing Contract (PSC) terms was built for resulting economic indicators.

3.      Development of the outcome

Net cash flow of each scenario is shown in Figure 1 and Figure 2. As shown, the project basically has negative cash flow in early years of investment that generates high positive cash flow in early years of operation.

Figure 1. Case 1 Cash Flow

Figure 1. Case 2 Cash Flow

4.      Selection of criteria

According to above cash flow, the economic indicators of each scenario is as follows (MARR=10%):
- Case 1: IRR 14.08%, NPV@10% USD 65.339 Million
- Case 2: IRR 13.44%, NPV@10% USD 59.644 Million

5.      Analysis

Based on economic indicators, case 1 had slighlt higher of IRR and NPV compared to case 2. In this analysis, case 1 could be selected for Plan of Development (POD).

6.      Selection of alternative

Furthermore, a new economic indicator, i.e. ERR (External Rate of Return) shall be applied in order to comprehend the nature of such cash flow. ERR directly takes into account the interest rate (Ɛ) external to a project at which net cash flows generated (or required) by the project over its life can be reinvested (or borrowed). ERR also describes a macro-economic measurement that looks at the overall impact of a financial move on your entire financial life. It involves the “big picture.’

Formula of ERR is as follows:

R_k = excess of receipts over expenses in period k,

E_k = excess of expenses over receipts in period k,

N = project life or number of periods, and

Ɛ = external reinvestment rate per period

Therefore, the ERR of each case generated by Goal Seek of Ms Excel (Ɛ=MARR) will be:

7.      Performance monitoring and post-evaluation of results

To summarize, the indicators of each case is shown in Table 1.

  Table 1.Economic Indicators of Gas Project

	CASE 1	CASE 2
IRR	14.08%	13.44%
NPV@10% (MUSD)	65,339	59,644
ERR	-0.82%	-0.57%

Using Table 1, case 1 has higher negative ERR compared to case 2. In this analysis, case 2 is preferable rather than case 1 since case 2 will generate more FV revenue per PV cost.  Then, case 2 will be proposed to management to be selected for POD. However, all two cases have negative ERR show that this gas development project is non-profitable project since ERR < MARR, regardless this project has IRR > MARR and NPV > 0.

Finally, when making financial decisions, it’s important to always think about not only what we expect to happen within the confines of the investment we are looking at (IRR), but also to look at what the consequences of this decision will be versus others we could make (ERR).

References:

·         Bridel, Wes. (2009). Rate of Return: Beyond the Basics. Retrieved from : http://www.kingdomcalling.com/2009/10/14/rate-of-return-beyond-the-basics/
·         How to calculate your Return on Investment. Retrieved from : http://www.fatpitchfinancials.com/392/how-to-calculate-your-return-on-investment/
·         Sullivan, G. William, Wicks, Elin M & Koelling, C. Patrick. (2012). Engineering Economic 15^th Edition: Chapter 5 Evaluation a Single Project, pp. 205-208