The Sensitivity of Profitability to Variations In the Economic Performance of Waterfloods

Abstract

Petroleum technology has improved to the point that reasonably accurate forecasts can be made of the performance of waterflood projects and of the cash flows which will result. Increased reliance on the predictions of economic performance has been accompanied by application of the mathematics of investment to measure profitability of proposed waterfloods. The internal rate of return method is at present the most popular yardstick used in measuring profitability. This paper investigates the effect on profitability of deviations from predicted performance. Various types of changes in costs and income are postulated, and their effects studied. In general, profitability proves to be most sensitive to the amount of oil recovered, but the speed of recovery is almost as important. Further analysis demonstrates the merit of purchasing prospective waterflood acreage using overriding royalties rather than cash alone.

Introduction

Waterfloods are profitable, but expensive. Furthermore, a waterflooding company may invest large sums of money and continue operations for a year or more before early returns first signal success or failure of a venture. Therefore, a sound evaluation of the economic prospects of the flood is vital. Fortunately, years of experience and mountains of experimental and theoretical studies have enabled engineers to forecast performance of waterfloods with a reasonable degree of confidence. From these forecasts, predictions of costs and income can be made which allow management to establish the value of a flood prospect. Mother Nature is too stubborn to sustain all these forecast, and the actual performance of many floods diverges widely from predicted performance. How much these divergences affect the value of a flood is of serious interest to management, and is the subject of this paper.

Measurement of Profitability

First, we must answer the question: how does management measure the value of a project? Although companies may consider other factors, most often it is the profit to be derived from a project that determines its value. Profit is the reward to the company for efficient production of crude oil needed by the rest of the economy. Profitability refers to the value of this anticipated reward. But how is profitability measured? Which is better: (1) to invest $500,000 in a flood which will return the investment plus a profit of $500,000 in 10 years, or (2) to invest the same amount in another flood which will return the investment plus a profit of $350,000 in five years? The simplest yardstick used in this problem is payout The project which pays back the investment cost quicker is the better project. Another popular yardstick is the ratio of profit to investment. Both yardsticks are still in use, but evaluators agree that they are too coarse to screen out the best projects from the many complex, competing proposals presented to most companies. Particularly in the last dozen years, industry has begun to apply more sophisticated yardsticks, mostly those which have been used by financiers for several centuries. Although many different yardsticks have been proposed and used, all the better ones recognize the time value of money, which payout and the profit-to-investment ratio ignore. The most widely accepted yardstick for profitability seems to be the internal rate of return. Many companies, however, prefer some other measure of profitability which, unlike internal rate of return, gives consideration to the value of money to that particular company (Profitability Index, net present worth, appreciation rate of equity, etc.). In many ways, these latter indices are more trustworthy. For the purposes of this paper. any of the preferred yardsticks is adequate. Since rate of return seems to be more universally understood and used, it will be utilized for our comparisons. Rate of return may be defined as that interest rate which, when used to discount future cash revenue, will cause the net present worth of the future cash revenue (income less operating expense) to equal the capital investment.

JPT

P. 924^