Project cash flow

The value of a project is decided not by how much has already been put into it, but by what it will bring in the future. We describe the future of a project as a series of sums of money spread over time. First come the payments for wells and equipment. Then come the receipts from the sale of oil, and the running expenses. At the end come the abandonment costs. This series is called the project's cash flow.

Every element of the flow has three characteristics.

• The sign shows the direction. An inflow is money coming in, with the sign “+”; an outflow is money going out, with the sign “−”. The same operation has a different sign for different parties: payment for drilling is an outflow for the subsoil user and an inflow for the drilling company.
• The moment is the date of actual payment, not of signing the contract or of delivery. If a drilling rig was ordered in October, received in February and paid for in March, then in the cash flow it is an outflow of March.
• The currency. Oil is usually sold for US dollars. Imported equipment is paid for in the supplier's currency. Wages, local services and taxes are paid in tenge (KZT). The company keeps its accounts in its base currency. In the model all amounts are converted into one currency at an assumed exchange rate, and this rate is itself an assumption of the model.

A real project has thousands of payments, from business-trip expenses to the construction of an oil treatment plant (a plant that cleans the oil and prepares it for sale). For analysis we group them into a few items and add them up within each item.

It is convenient to combine all payments to the state into one item. For the cash flow it does not matter what a payment is legally called. What matters is how much it takes from the project, and when. The lesson Petroleum fiscal systems and taxation covers how these payments are structured. The lesson Cash flow model of an oil and gas project covers how production, prices and costs are forecast year by year.

Capital expenditure creates or expands what will work for years: a well, a plant, a pipeline. Operating expenditure keeps what has already been created working: it pays for staff, energy, chemicals and routine maintenance.

The boundary between them is not always obvious. Before production starts, almost all spending is classed as capital. After start-up, the same kind of work can fall into either category. Routine well servicing is usually operating expenditure. A major repair (workover) that switches the well to another reservoir layer, or the drilling of a sidetrack (a new branch from the existing well), is more often capital. The company's accounting rules and the tax legislation decide.

If both kinds of cost are outflows, why distinguish them? There are two reasons.

1. Taxes. Operating expenditure, as a rule, reduces taxable profit in the same year. Capital expenditure is deducted gradually, through depreciation, over several years. The total of the deductions is the same, but it comes later. This means that the tax is paid earlier.
2. Reporting. In accounting, capital expenditure becomes an asset and is written off to expense in parts, while operating expenditure reduces profit at once. So with the same payments, more capital expenditure means higher reported profit in the nearest years. For the financial statements this can look advantageous. For the cash flow it does not, because the tax goes out earlier.

Any decision changes the company's future. We appraise not all of the company's money but the difference between two versions of the future: “with the project” and “without the project”. This is the incremental cash flow. The comparison is “with” and “without”, not “before” and “after”, because production from the old wells would have declined even without the new project.

• Sunk costs are not counted. The money already spent on seismic surveys and an exploration well cannot be recovered whatever decision is taken. For the decision to develop, only future flows matter. The exception is the future consequences of past costs: if they can still be deducted from the tax base (the profit on which tax is calculated), this tax saving is an incremental flow.
• Opportunity costs are counted. If the project takes up spare capacity in the company's own pipeline that would otherwise be let to other companies, the lost transport fee is a cost of the project, although no one makes a payment.
• Side effects are counted. A new well that partly takes oil from neighbouring wells in the same accumulation (an oil pool in the ground) brings only the increase in production, not its whole flow rate (see Acceleration projects and incremental analysis).
• The company's overheads are counted only if the project really changes them: new office staff — yes, a share of the rent of an existing office — no.
• Financing is usually not mixed with the project. Loans, interest and their repayment are not included in the project's cash flow, and the cost of money is taken into account through the discount rate. To subtract interest and then discount again is to count the cost of money twice.

A cash flow model is a table with the items in its rows and the periods in its columns. It simplifies reality: instead of thousands of payments, a few sums a year. The level of detail depends on the task: monitoring a budget, calculating taxes or making an investment decision. A model should not be more precise than its source data. Four choices decide its structure.

Period

Usually a calendar year. A half-year is used when the calculation of some tax needs it, and a month for short projects lasting a few years or less. Do not depart from calendar years without a reason, because budgets, financial statements and taxes are aligned with them.

Moment of the period's flow

All the payments of a period are replaced by one sum, the NCF, and assigned to a single moment (the aggregation point). If payments are spread more or less evenly within the year, mid-year is the most accurate. If they are not (for example, there is a large payment at the start of the year), we choose the moment from the actual schedule.

Time origin

The date to which the calculated indicators are referred: today, the date of the decision or the start of the project's first year. When flows are simply added up it does not matter, but it becomes essential as soon as the flows are discounted, which means brought back to the money of that date (Discounting and present value).

Monetary units

Nominal (money of the day) is the money of the corresponding year, including future inflation (the rise of prices). Such a model can be tied directly to the budget and the calculation of taxes. Constant prices of the base year (real terms) are sums of the same purchasing power, which are easy to compare between years. Do not mix the two in one model (see Inflation: nominal and real money).

Now we put together the cash flow of an assumed oil field. Two years go on drilling and development. Production starts in the third year, quickly reaches a plateau and then declines. In the tenth year the field is abandoned. The amounts are in constant prices of the base year. The tax regime is simplified for teaching purposes and does not reproduce the legislation of any country.

This shape is typical of production projects. First come several years of negative flow for additional exploration, drilling and development. Then production grows fast up to the plateau. After that it declines gradually as production falls, until the income stops covering operating expenditure (this point is the economic limit). At the end comes an outflow for abandonment. Income tax in the first years of production is often small, because depreciation deductions reduce it, and it grows later. In the example this can be seen in year 8: revenue is lower than in year 7, but taxes are higher, because the depreciation has ended.

Profit in the financial statements answers the question of how the company performed over the year. It is calculated under accrual rules (income and costs belong to the period they relate to, not to the moment of payment): income is assigned to the period of sale, and capital expenditure is spread over the years through depreciation. Cash flow answers a different question: how much money the project took or brought in, and when.

• Depreciation reduces profit but not money: the money went out earlier, when the equipment was paid for.
• Capital expenditure reduces money at once, and profit gradually. In the construction years the project absorbs tens and hundreds of millions, but in the profit statement this is hardly visible.
• Profit depends on the accounting policy: the depreciation method, the classification of costs as capital, and provisions (money set aside for future costs). Cash flow is the fact of money moving. The choice of accounting method affects it only through taxes.
• To assess value, we need the moment of payment. Only money actually received can be invested, spent or paid out to shareholders, and the value of a sum depends on when it is received.

Over the whole life of a project, total profit and total net cash flow are the same, provided all the capital expenditure is eventually written off. What differs is how they are spread over time, and the value of the project depends on exactly this.