# Investing in natural gas: drilling down into the risksA BG Group case study

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## 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)
• costs
• 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.

BG Group | Investing in natural gas: drilling down into the risks
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