This paper offers a critique of, and suggests an alternative to, commonly used methods – including the method stipulated in the 2011 Guidelines for Application of the Petroleum Resources Management System (hereafter, "PRMS Guidelines"), promulgated by the SPE and others – for calculating the economic limit test ("ELT") for upstream petroleum projects. The ELT determines the assumed project abandonment date.
In particular, the authors fault the PRMS Guidelines-prescribed ELT method because it a) uses a measure of revenue which is often much higher than what Investors actually receive in projects governed by fiscal arrangements such as Production Sharing Contracts ("PSCs"); b) ignores abandonment costs and income tax liabilities, even though these are real and often material cash outflows; and c) appears to ignore the time value of money. These shortcomings can cause the PRMS ELT to assume abandonment dates which result in Net Present Values ("NPVs") of discounted future cash flows which are lower than an Investor could achieve by using a different abandonment date. In such cases, the PRMS approach is tantamount to Investor value destruction.
This paper presents a simple, transparent and mathematically sound alternative ELT calculation method, which considers all Investor NPV-relevant items, including abandonment costs, income taxes, the time value of money, and, in the case of PSCs, actual Contractor cash revenue, to determine which abandonment date maximizes Investor NPV. The method avoids the circularity which can arise when attempting to consider abandonment costs while calculating a future uncertain abandonment date.
The paper compares the results of using the authors' method and the PRMS method in example valuations. These examples show that the authors' method can result in different economic limits/abandonment dates – and thus higher NPVs – than the PRMS method. The authors' underlying Microsoft Excel model accompanies this paper.
The findings are relevant to value-focused investors -- especially those in projects which are governed by PSCs, and/or involve large abandonment liabilities pending in the short-term or long-term -- and to parties who issue or otherwise use PRMS standard valuations.