Introduction
Today’s column continues consideration of Rystad Energy’s modelling of the cost of delay in the Payara Project, incurred from the delayed approval of ExxonMobil and partners’ final investment decision (FID), which had been submitted to the Government of Guyana (GoG) last year. As indicated last week, today’s column will focus on what I have labelled as the “two most crucial variables” in that modelling exercise. These are: 1) the discount rate, and 2) the role of externalities in arriving at the results of Rystad Energy’s discounted cash flow (DCF) analysis of the cost of the Payara delay.
Last week I had referred to the uncertainty that has creeped into the determination of whether there is an actual delay or not. Rystad Energy’s results suggest that, at the time of its publication (back in July 2020), there was already some delay, as the company had costed the “already delay.” As indicated, Hess Corporation’s spokesperson had indicated later (September 2020) that, if approval was given by the GoG before the end of that month, the project would be on schedule! I am in no position to clarify, which version presently holds.
To add to the confusion, there were press reports towards the end of September, claiming that the Payara project had been approved. The Natural Resources Ministry clarified however, stating that discussions on the Payara FID are still ongoing, and that, “the government is hoping to meet the September deadline”, as previously announced.
In what follows, I first address the notion of the discount rate as applied in Rystad Energy’s DCF. And, following this, I address the difference between using private and social costs in the DCF.
Discount Rate
Over this long series of columns on Guyana’s infant oil and gas sector, I have made several references to DCF of petroleum projects. DCF is used to determine the viability and/or profitability of prospective projects. It is constructed on the basis of projected cash flows into and from the project. The underlying economic concept behind DCF analysis is termed the time value of money. That is simply, the common sense recognition that a sum of money available to an economic agent today has, generally, greater value than the same sum made available some time into the future. This is evident if one recognizes that money in the future rather than now, runs the risk of its value depreciating. For example, through inflation or loss of potential income it can earn (interest), if it is deposited into a reliable bank.
Petroleum projects are typically long-term and costly. They, therefore, require large cash injections over extended periods of time during the construction phase of the project, before any petroleum is produced and sold. Expected/projected cash inflows into projects take place when their products are sold. These together with the cash outflows by the investor (to construct the project, over time) are discounted to arrive at their present values. The rate at which these cash flows are discounted to establish their present value is termed the discount rate.
Because the discount rate is used in DCF analysis to arrive at the present value of future cash flows, it is crucial to the determination of the viability and profitability of every petroleum project. Indeed, we can state, formally that, in DCF analysis, it is the rate used to determine whether to go ahead with a project or not!
Readers may well ask, “How is the discount rate arrived at?” In the simplest terms, it is based on the cost of capital used in a project. That cost of capital is derived from: 1) the return the investors would accept for investing their own funds into a project (equity); and 2) the cost of external funds (debt) that is taken on to finance the project. There is typically in most petroleum projects a blend of equity and debt. The average of the two is therefore weighted, to arrive at the cost of capital.
Further, experience has revealed that, in projects like Payara, investors routinely add risk premia. In the case of Payara, this would reflect that it is an offshore project located in a frontier region!
The conclusion, therefore, is that if there is a positive net discounted present value, that is, cash inflows into the project exceed cash outflows of the project, and the discount rate as indicated above is used in the DCF analysis, then the project should go ahead. Needless to stress, special care must be applied in arriving at this discount rate, as changes in the rate will change the outlook on projects.
In the next Section, I consider the second key variable used to construct the cost of delay modelling for the Payara project.
Private versus social costs
As pointed out previously, the Payara project is a joint venture (JV). It blends public enterprise (GoG as Resource Owner) and private enterprise (international oil companies (IOCs) as Contractor) led by ExxonMobil as Operator. As such the use of private costs in the calculation of the project’s Net Present Value (NPV) is acceptable. So too would be the GoGs estimation of the social costs of delay. There is no evidence that the latter estimation has been pursued. The question arises therefore, whether a priori will likely to be a big difference to the outcome.
As briefly indicated last week, private costs would in this circumstance, refer to those expenses/ costs the Contractor pays for producing crude oil and gas from the Payara finds. Social costs, however, would include these costs as well as others. For example, other such costs could be pollution costs (oil spills, flaring, etc.) that may arise from the project but are not covered by the Contractor. These costs are external to the Contractor, but borne by the GoG on behalf of society, as a whole. Typically, private costs are less than social costs because social costs include external costs, which private costs do not entertain. Therefore private costs are only a fraction of social costs and social costs cover both private costs and externalities.
Conclusion
I continue this discussion next week and link the analysis of “externalities” to it.