Page 6: Economic modelling
Economists can then develop models projecting the likely costs and revenues of developing new fields. Essential components of these models are:
- revenues (price x volume)
- government take (e.g. taxes because the blocks that companies bid for are government property).
Revenues less costs,less government take = the net cashflows which are discounted to give the NPV. BG Group then uses all of this information to calculate the EMV of decisions.
EMV = (NPV of success x chance of success)
(NPV of failure x chance of failure)
The following example uses estimated returns expected from BG Group committing itself to drilling one exploration well. The net present cost will be £16m. There is a 16% chance that the three year project will be a success, yielding a return at NPV of £114m.
First of all work forward across the diagram from the decision fork where the choice is: "drill exploration well" or "don't drill exploration well".
Next, set out the probabilities of gas being discovered and the NPV of success or failure (these are based on the geologists' and economists' calculations).
If the well is not drilled there will be a return of £0.
If the exploration well is drilled and no gas is found there will be a loss of £16m. There is an 84% chance of this being the case.
If the exploration well is drilled and gas is found there will be a gain of £114m. There is a 16% chance of this happening.
We can now work out the EMV if the decision is made to go ahead with exploiting the field.
EMV = (£114m x 16%) (-£16m x 84%) = £4.8m
Therefore, on a risked basis drilling the well is attractive on economic grounds in that it generates a positive EMV. The opportunity would be presented to management to compete for funds in the capital allocation process.