# W7.1_HPO_Determining The Contractor’s IRR in Production Sharing Contract

1. Problem Statement

Production Sharing Contracct (PSC) is a kind of contract between government and investor to share the production of petroleum after deduction of extraction cost. Government and contractor share the risk and result of production. How the contractror should calculate the real IRR of their investment recovery through PSC?

2. Development of Feasible Alternatives

According to Sullivan, calculating IRR is defined by the present value of sum of net revenues or savings for kth year equal to present value of some of net expenditures including investment costs.

∑Rk(P/F,i%,k) = ∑Ek(P/F,i%,k)

The alternatives of calculating IRR of the PSC, should we calculate the IRR from net revenues and expenditures from:

• Total Cash Flow generated, or
• Contractor’s Cash Flow Earned by Contractor

We should define which one of those two really represents the real IRR earned by contractor.

3. Development of The Outcomes of Each Alternative

Assumption of operation’s going as:

• The petrolum product is oil only. All data of reservoir is coming from the prediction of the latest reservoir volume certification.
• The contractor finished their exploration activities at contract year 10 and will operate for the rest 20 contract years of production.
• Reservoir engineer said the production could be maintained for 5 years plateau at 25,000 bopd without production intervention or stimulation. The initial production is 60% of the peak and plateau production because the whole wells are not ready yet drilled in year 1.The production will have declined rate at 10% starting from production year 7 or contract year 17.
• The capital investment in production year 0 is US\$400 M with 80% on immovable and 20% on movable. From those capital investments of immovables, US\$ 250 M will be used for the oil plant and the rest will be for wells. The capital investment in year 2 will be only for drilling the wells to reach the maximum production.
• The operating cost is assumed 20% of the first total capital cost which includes 15% of maintenance cost, and 5% of overhead cost.
• The inflation is assumed at 5% assuming the components of cost will be 60% from abroad and 40% from Indonesia. Inflation of Indonesia according to the latest data of Bank of Indonesia is 8.32% per year and we assumed the service and material coming denominated in US\$ will follow US inflation at 2.44% (effective rate for 20%). The cummulative then is at 4.79% and conservatively we assume to stick at 5% inflation.
• The impurities and water factor increases at 10%/year and should be considered in maximum capacity modelling. Therefore we have to model and calculate the maximum capacity of oil plant. From the model below, the maximum capacity of oil plant is 42,340 bbls per day.
• Oil price basis at year 1 production is at US\$ 100/bbl and according to the data of oil price of Department of Energy of USA, the oil price in late 20 years has an effective average year on year of 8.95% of WTI and 10.19% of Brent. Due to high volatility of crude oil price, I suggest we should do conservative to the assumption 0f 5% of oil price growth.
• All calculation here needs excel application because the free cash flows are quite varies.

Assumed in this sample of common & simple type of PSC:

• The contract is 30 years.
• The PSC will recover all costs related only to the exploration and production of petroleum. Therefore, the sunk cost of the exploration cost will also be recovered and calculated as initial unrecovered cash outflow of investments.
• The capital assets categorized into 2 types: movable and immovable. Movable has 2 years life and the immovable has 5 years life . The assets life is quite short for oil product accelerated from the actual useful life. The depreciation method is straight line method.
• The calculation for cost recovery is Total Cost Recovery = Unrecovered Cost + Operating Cost + Depreciation Cost. If the total cost recovery is higher than the revenue earned at one period of year, the maximum recovery will be as much as the the revenue. The rest of cost will be calculated at the following year as unrecovered cost.
• The share ratio between government and contractor is simply 80:20, thus the net revenue to be split to contractor is 20% (net clean of income tax and dividend royalty tax).

4. Selection of Acceptable Criteria

The criteria is to see the most reliable IRR rate basis for the contractor, which gives the real return will be earned by contractor.

5. Analysis of Comparison Between Alternative and Criteria

If we see to the cash flow of whole contract we will see below:

(in 000 US\$)

Figure 1.

The contract gives the IRR 83.63% quite enticing high , but the IRR of figure 1 is only for the contract (PSC) not applied to the contractors really earned. We should apply the PSC scheme to get the real cash flow stream to the contractor below:

(in 000 US\$)

Figure 2.

The real IRR of contractor is only 29.12% due not all the oil products will be taken and owned by contractor but should be shared between government and contractor.

6. Selection of The Best Alternative

Because for the figure 1 is only for the contract IRR, the contractor should apply the PSC scheme to its cash flow stream. The real cash flow stream of contractor’s will derive the real IRR of the contractor as much as 29.12%.

The contractor should put the real IRR of 29.12% to their investment portfolio to prevent the exaggeration of the real payback.

References:

Anonym (2013). Inflation. [ONLINE] Available at:http://www.bi.go.id/web/en/Moneter/Inflasi/Data+Inflasi/. [Last Accessed 17 November 2013].

Anonym (2013). Inflation Calculator. [ONLINE] Available at:http://www.usinflationcalculator.com/. [Last Accessed 17 November 2013].

Anonym (2013). Weekly Petroleum Status Report. [ONLINE] Available at:http://www.eia.gov/petroleum/supply/weekly/. [Last Accessed 17 November 2013].

Sullivan, W. G., Wicks, E. M., & Koelling, C. P. (2012). Evaluating A Single Project . In Engineering Economy (15th ed., pp. 178-222). Upper Saddle River, N.J: Prentice Hall.

Sullivan, W. G., Wicks, E. M., & Koelling, C. P. (2012). Depreciation and Income Taxes . In Engineering Economy (15th ed., pp. 288-333). Upper Saddle River, N.J: Prentice Hall.