THE IMPACT OF OIL PRICE ON PRODUCTION SHARING CONTRACT BLOCK 12WEST IN NAM CON SON OF PETROVIETNAM EXPLORATION PRODUCTION CORPORATION

NATIONAL ECONOMICS UNIVERSITY CENTER FOR ADVANED EDUCATIONAL PROGRAMS=========== ========== BACHELOR’S THESIS OF FINANCE TOPIC: “THE IMPACT OF OIL PRICE ON PRODUCTION SHARING CONTRACT BL

NATIONAL ECONOMICS UNIVERSITY CENTER FOR ADVANED EDUCATIONAL PROGRAMS

=========== ==========

BACHELOR’S THESIS OF FINANCE

TOPIC: “THE IMPACT OF OIL PRICE ON

PRODUCTION SHARING CONTRACT BLOCK 12WEST IN NAM CON SON OF PETROVIETNAM EXPLORATION PRODUCTION CORPORATION”

Student’s name Student’s ID

Class Intake Internship guide Supervisor

: Le Lan Khanh : 11121951 : Advanced Finance 54A : 54

: Mrs Nguyen Ngoc Mai : PhD Nguyen Thi Hai Duong

Rationale of the research 7

Objective and question of the research 8

Scope and methodology of research 8

Literature review 9

Outline of the research 9

CHAPTER I: PETROLEUM CONTRACT AND ITS FISCAL SYSTEM 10

1.1 The oil and gas industry 10

1.1.1 History of the oil and gas industry 10 1.1.2 Types of petroleum contract 12 1.1.3 Fiscal system of Production Sharing Contracts 13 1.1.3.1 Definition 13

1.1.3.2 Features 14

1.2 Cost recovery, oil split and taxes 15

1.3 Factors affecting the financial performance of a project 17

1.4 Criteria to measure the financial performance of a project 18

1.4.1 Net Present Value 18 1.4.2 Internal Rate of Return 20 1.4.3 Sensitivity analysis 23 CHAPTER II: SITUATION OF FINANCIAL PERFORMANCE OF THE PROJECT “PSC 12WEST” 24

2.1 Introduction of PetroVietnam Exploration Production Corporation 24

2.1.1 Foundation, History and Development 24 2.1.2 Organizational Structure and Functions 25

2.1.3 Petroleum contract in PetroVietnam Exploration Production Corporation 27

2.2 Project No 12West in Nam Con Son 30

2.2.1 Government take and contractor take in project no 12.west – Financial performance 30

2.2.1.1 Terms and conditions in the production sharing contract offshore block 12West in Nam Con Son basin 30 2.2.1.2 Economic evaluation 36 2.3 Assessing the impact of oil price on the project 39

2.3.1 The oil price trend from 2006-2016 39

Abstract

Author Le Lan Khanh

Tittle The impact of oil price on production sharing contract Block 12West in

Nam Con Son of PetroVietnam Exploration Production CorporationYear 2016

Language English

Pages 61

Supervisor PhD Nguyen Thi Hai Duong

The main objectives of this research is to understand how a production sharing contract

of oil and gas works as well as evaluate the economic efficiency and the impact ofdecreasing oil price on the petroleum project Block 12West in Nam Con Son Readerswill get clearer picture of petroleum upstream sector, especially the most popular type ofpetroleum contract _ production sharing contract, understand more about how the profit

is divided between government and investors as well as the role oil prices play in aparticular oil and gas project

First and foremost, this work is dedicated to my supervisor, lecturer Nguyen Thi HaiDuong, for being a very thoughtful, supportive teacher and advisor Without her help, Icould not have finished this graduate internship report

Secondly, it is a great pleasure for me to work and submit my report on the graduateinternship at PetroVietnam Exploration Production Corporation For this, I am sincerelythankful to my sponsor, Ms Nguyen Ngoc Mai for spending lots of her time guiding me

at work And to all of PVEP’s employees at project finance department, I would like tothank them for treating me as a friend, a family member, and giving me wonderfulexperience during the time of my internship

Last but not least, I would like to thank all my respectable lecturers at National EconomicUniversity for providing me with essential knowledge of Corporate Finance

STATUTORY DECLARATION

I herewith formally declare that I myself have written the submitted Bachelor’s Thesis independently I did not use any outside support except for the quoted literature andother sources mentioned at the end of this paper

Hanoi, / /2016

Signature

LIST OF TABLES

Table 2.1 Petroleum contracts of PVEP 29

Table 2.2 Minimum work and financial commitment 33

Table 2.3 Royalties and tax 34

Table 2.4 Share of profit oil between Contractor and PVN 34

Table 2.5 Estimated costs for project block 12West 35

Table 2.6 Economic indicators of project Block 12West 38

Table 2.7 Economic indicators for project Block 12West of PVEP 40

LIST OF FIGURES

Figure 1.1 Types of Petroleum Agreement 14

Figure 2.1 Organizational chart of PVEP 27

Figure 2.2: Calculating the contractors’ take and government take in project block 12West 37

Figure 2.3 Estimated net cash flow of the project Block 12West 39

Figure 2.4 The oil price trend from 2006 to 2016 42

Figure 2.5 Sensitivity analysis of the project block 12 West 43

Figure 2.6 Oil suply, demand and price 44

Rationale of the research

Oil is one of the most important energy sources in most economic activities, therefore thevolatility of oil prices has a significant impact on the economy Fluctuating oil prices inhistory had led to high inflation and prolonged recession in several countries around theworld Since the record of dramatic growth in oil price for the first time in the 1970s andits unpredictable changes after that, oil has become a major concern for policy-makers tostrengthen oil efficiency and diversify alternative resources Besides, oil price has alsobecome one of the main indicators when it comes to economic analysis In Vietnam, theimpact of oil prices on the economy cannot be overlooked because although Vietnam is acrude oil exporter, our country still imports oil-related products Moreover, Vietnam'seconomy is more open these days It is clear that the sharp increase in oil price, alongwith that of other commodities, has resulted in a sharp growth in domestic inflation,which makes it difficult for efforts to control inflation of the State Bank of Vietnam in

2014 The current low oil prices (about $35 per barrel) create a new challenge for oilexploration and exploitation companies to maximizing theirs revenue These days, there

is nobody seems to be able to forecast with any confidence the oil price in long term.Prices may go up significantly, as they did in the period of 5 years (2009-2014) or maycontinue to decrease dramatically to levels lower than most analysts expect (below $30per barrel) There is no doubt that in most of the time, oil analysts have been consistentlywrong about forecasting oil prices fluctuations

On behalf of Petro Vietnam, PVEP performs business operations and capital investment

in other enterprises operating in the field of oil & gas exploration and exploitation.PVEP’s activities of oil & gas exploration and exploitation are taking place bothdomestically and aboard The Corporation carries out the function of investmentattraction, studying hundreds of kilometers of seismic, promoting the Contractors' drillingand exploration process There have been a number of appraisal wells which are beingexploited in order to contribute in Vietnam’s reserves addition and increasing of miningoutput Nowadays, since investing in exploration and production abroad costs a largeamount of money, and the oil and gas reserves in Vietnam are gradually declining, PVEP

has been expanding its exploration Investing a petroleum field in Nam Con Son basin is

to follow the strategic development of the corporation in this period

Objective and question of the research

 Objective

The study aims at analyzing a case study in which data have been collected regarding anopportunity to invest in Nam Con Son basins With finance knowledge gaining atuniversity, I shall perform an analysis on whether or not economically feasible the project

is in order to have a general picture about the impact of oil price fluctuations on aparticular petroleum project

 Research questions

In order to further understand how the objectives of this study will be achieved, thesefollowing research questions are introduced:

- What is the petroleum contract?

- What are the fiscal components being stated in a petroleum contract?

- What is the role of oil price when it comes to following financial activities negotiated inthe petroleum contract?

- What are the terms in the petroleum contract Block 12West in Nam Con Son?

- How does the fluctuating oil price affect the project Block 12West in Nam Con Son?

- How can PetroVietnam Exploration and Production can improve the current situation?

Scope and methodology of research

 Scope of research

This thesis focuses on evaluating the petroleum contract block 12West in Nam Con Son,which has duration of 25 years (2009-2034), especially to evaluate the impact ofcurrently decreasing oil prices on the project in terms of financial activities

 Source of data

Input data including financial terms in the contract and minimum commitments,estimated product quantity, estimated cost for CAPEX and OPEX Besides, someprevious research papers on the same topic and information acquired from the Internetand textbooks are carefully selected as references

 Methodology

The study focuses on statistical analysis as a tool for evaluating efficient project.Economic feasibility shall be evaluated base on the following methods: Net Present

Value (NPV), Internal Rate of Return (IRR).The report also includes evaluation onsensitivities of factors affecting the economic feasibility of the project.

It can be seen that the oil price elasticity of demand is quite low which refers that thechange in oil demand generates the small change in oil price (Nesvisky, 2009) Adramatic decrease in oil quantity induces a sharp boost in oil price and oil price dropssignificantly because of a dramatic increase in oil quantity When this ratio is low, therise of oil price has no impact on spending Therefore, it has not influenced on oildemand or increased the oil price yet When the oil price goes up at a certain level, thespending for oil will increase significantly, which results in the downward demand of oiland oil price reduction

According to the International Energy Agency (IEA), the oil surplus is expected to grow

to 1.4 million barrels per day in 2016 In addition, if Iran reaches a nuclear agreementwith Russia, China, France, Germany, the United Kingdom, and the U.S., they couldimmediately add up to 500,000 barrels per day of oil to an already oversupplied market.,which leads to a sharper decline in oil price The falling oil prices have put incrediblepressure on capital-intensive oil and gas projects in Vietnam, such as offshore drillingand petroleum exploration In addition, many companies have cash flow challenges due

to crude oil price decline that affected their capital expenditure (Joseph Dawha, 2015).With this situation, making decision on which project should be invested is veryimportant There are several key managerial indicators or economic parameters that are

considered to evaluate the feasibility of a project, which include Net Present Value andInternal Rate of Return Patrick R Delaney (2007) reviewed that the NPV methodcalculates the expected monetary gain or loss from a project by discounting all expectedfuture cash inflows and outflows back to the present point in time using the requiredappropriate rate of return A positive NPV shows that an investment should be accepted,while a negative NPV shows that the investment should be rejected (Colin, 2006).Meanwhile, Internal Rate of Return (IRR) is another technique which is similar to NPV

in using the time value of money, but results in answer expressed in percentage form(PaulineColin, 2006) In addition, IRR method calculates the discount rate at which aninvestment’s present value of all expected cash inflows equals to the present value of itsexpected cash outflows It also means that IRR is the discount rate that makes NPV=0.Managers making decision based on IRR should choose the investment which has theIRR greater than the original cost of capital (Vũ Công Ty, 1996)

Outline of the research

Chapter I: Petroleum contract and its fiscal system

Chapter II: Situation of financial performance of the project “PSC 12West” illustrates

the current situation of the project as well as the impact of oil prices and PVEP’s

challenges

Chapter III: Solutions and recommendation

CHAPTER I: PETROLEUM CONTRACT AND ITS

FISCAL SYSTEM

1.1 The oil and gas industry

1.1.1 History of the oil and gas industry

Many oil price variations in the history are associated with the oil supply negativelyaffected by political events taking place in many different oil-producing regions of theworld Chronologically, the price of oil is affected by many events, such as the YomKippur War in 1973, the oil embargo from 1973 to 1974 in Saudi Arabia, the IranianRevolution of 1978- 1979, Iran-Iraq war of 1980-1988, the Persian Gulf war in 1990-

1991, the crisis in Venezuela in 2002, the Iraq war of 2003, the uprising in Libya in 2011,and recently hostilities especially in Iran and Syria These events adversely influence onthe production and transportation of oil, as oil supplies decline, thereby reducing oilprices

As contributing a large supply of oil production worldwide, the OPEC countries and largeoil producers likely to control oil prices by their policies In the past, OPEC hastraditionally adjustment of production capacity to alter the supply and price within atarget band of OPEC Without the adjustment policies of OPEC, short-term fluctuations

in demand and supply of oil will have a much stronger impact on oil prices However,OPEC's policies can also cause sharp fluctuations in oil prices to fulfill their other goals.For example, oil prices rose sharply in the period 1973-1974 year was caused by inMarch 10/1973 announcement of OPEC in which OPEC cut on oil production by 5%until the Israeli military completely withdraw from all regions they occupied in Arabcountry since the war in 6/1967 and the legal rights of the Palestinian people are restored.The record increased in oil prices for the 2007-2008 period non-OPEC oil producersagreed not to increase production In contrast, that Saudi Arabia does not complied to oilsubsidies in 1986 made oil prices plummeted from $ 27 / barrel to 14 USD / barrel.Similarly, the end of 2014 when in non-OPEC countries grew their oil output quantity,OPEC countries have changed the policy’s objective to protect market share bymaintaining production ceiling at 30 million barrels / day instead of cutting output todefend prices

It can be said that oil and gas field is a leading industry of almost every nation because itnot only makes enormous economic contributions to the country but also acts as one ofthe most necessary energies for our lives

In Vietnam, oil and gas industry is quite young and just starting to get adequate attentionsfrom the government recently Petroleum being collected primarily beneath thecontinental shelves contributes to supply energy and fuel, enhances exports to othercountries, and creates stable movements for the country’s economic development

Vietnam has started exploration and research activities since 1945 In 1969, Federation ofGeology No.36, formally known as Geology Team No.36, had a mission to undertakeresearches and explore petroleum sources in nation In 1975, General Department ofPetroleum and Gas VN was established on the basis of geological federations and part of

36 General chemical medicines In 1976, the natural petroleum was firstly developed inTien Hai, Thai Binh In 1981, there was an establishment of Vietso, a petroleum jointventure between Vietnam and Union of Soviet From 1984 to 1986, the first rig ofVietnam, as known as MPS-I, was built at Bach Ho In 4/1990, General Department ofPetroleum VietNam merged into the heavy industrial sector

The petroleum industry has many privileges because it is a strategic sector for economicgrowth and national security Specifically, this sector has been received efficient supports

of capital, technology… from the government since its foundation Investment Law andPetroleum Law have also been established with various of favorable geologicalconditions so that the industry can take advantage of Moreover, the State had supportedthem in constructing Dung Quat Oil Refinery along with the collaborative supports forthe National Oil Group to explore and exploit crude oil from abroad Appropriatedevelopment and expansion plans have been applied successfully As a result, thedomestic market share of oil and gas industry accounted for about 35% In addition, thesynchronization of petroleum activities in all fields, from the main activities such asexploration, production and distribution to oil-and-gas-related services, or from otherpetroleum outputs such as electricity to financial sector, is also a factor contributing tothe industry’s development

However, our exploration and production of oil and gas is still heavily dependent on theworld’s oil prices The amount of oil reserves is now seeing a dramatic reduction due tothe fact that there are more fields being put into production than ones being discoveredand explored Also, expansion plans for exploration and production in deep water areasrequire a large amount of money and these areas are now in war of sovereignty withChina

1.1.2 Types of petroleum contract

In general, there are two main systems of petroleum contract all around the world:concession/ licensing system and contractual system The basic difference between thesetwo types of petroleum system is the ownership of the resources

In terms of concessionary fiscal system, oil company is allowed to take ownership of theresources when petroleum is produced More importantly, they produce at their own riskand expense After commercial production is obtained, royalties and taxes are paid for thehost country of the resources This type of petroleum system is very popular amongdeveloped countries, such as US, UK and Canada

Figure 1.1 Types of Petroleum Agreement

Under contractual systems, there are two types of contract: Production sharing contractand joint venture contract The former one is very popular in developing countries whilethe latter is less preferable

Before the introduction of PSCs, concessionary contracts dominated the early days of thepetroleum industry This type of contract, which is also called tax/royalty system,typically involves the transfer of the land ownership from the government to privateinvestors However, this approach became less popular when the nationalism euphoriaamongst oil producing countries led to the introduction of state participation as a method

to end foreign investors’ domination

Under PSCs, the oil company gets a share of oil production (usually in kind), and ownsthis share of oil produced Under a service contract, the oil company is paid a fee forproducing the oil The oil company is allowed to recover some of its costs in both types

of contract, but usually bears all the risks when exploration is unsuccessful

1.1.3 Fiscal system of Production Sharing Contracts

1.1.3.1 Definition

A production sharing contract (PSC) is a contractual agreement between a contractor and

a host government whereby the contractor bears all exploration costs, risk, developmentand production costs in return for a stipulated share of the production resulting from thiseffort (Johnston, 2003) The contractor might be one or more international oil companiesauthorized by the host government (usually represented by its ministry of petroleumoperations within the area specifically described in the agreement in accordance with theterms of contract

The rights and obligations of host government and international oil companies, thecontract area, the fiscal regime and other conditions as well as the production sharingformula are predetermined and embodied in the contract terms

1.1.3.2 Features

The basic terms of a PSC are usually determined by legislation in the host country andform the basis of negotiation between the host government and the oil company In itssimplest form, a Production sharing contract has the following components:

 Cost Oil: the share of production by which the oil company recovers their capital andoperating expenditures Normally, most PSCs have a limit cost recovery

 Profit Oil: this is the amount of oil remaining after cost recovery oil, which is sharedbetween host government and their contactors according to an agreed ratio The portion

of the profit oil allocated to the international oil company (IOC) is usually negotiable andstipulated in the agreement The basis of the spilt varies in different countries and maydiffer even within the same country depending on the fiscal regime of the hostgovernment (HG) and also the level of production which could be a flat rate or slidingscale

 Royalty: this is considered as a proportion of gross revenue According to the Oxforddictionary, royalty is “a sum of money that is paid by an oil or mining company to theowner of the land that they are working on.” It is to commensurate for the use ofproperty, usually copyrighted works, patented inventions, or natural resources, expressed

as a percentage of receipts from using the property or as a payment for each unitproduced In a PSC, it is a levy calculated as a percentage of production, which is paid tothe host government as rent for the grant of petroleum operating rights to international oilcompanies and the rate is determined by legislation It is taken right off the top (aftergross revenue)

 Corporate income tax: The IOC share of the profit oil is subject to income tax thepercentage of which is dependent on factors such as the geological endowment and thequality of hydrocarbons, which may be based upon a flat rate or sliding scale Sometimes,this is paid by the national oil company (NOC) on behalf of the IOC

Other provisions of a PSC include the contract area, work program and budgets,decommissioning, pricing, commercialization procedure, treatment of associated gas,duties, compensation, and dispute resolution procedure (usually arbitration)

1.2 Cost recovery, oil split and taxes

Besides the feature of a PSC which title to the resources belongs to the host government,the cost recovery limit is the only true distinction between concessionary systems andPSCs (Daniel Johnson) The role of cost recovery is to create an avenue forcompensating IOCs for the risks and expenses in exploration, development andsubsequent operation cost which they have to bear alone since the NOC does notcontribute towards any of these It serves as a tool for balancing the IOC objectives ofprofit maximization and HG requirements for developing its natural resources at minimal

or no cost with negligible economic, environmental and social impacts (John, 2000)

In spite of the fact that its motivation is to encourage oil organizations recoveringinvestment, its composition shifts from nation to nation Some do not permit costrecovery except for giving the contractors an amount of production that may range from44% to 50% relying upon the contract area, while others have no restrictions on costrecovery, such as the Indonesian PSC However, the general practice is that hostgovernments place a ceiling on cost recovery and stipulate the costs that may berecovered (Bindermann, 1999)

Cost Recovery is the means by which the contractor recoups costs of exploration,development, and operations out of gross revenues There is usually a limit or ceiling tothe amount that can be claimed by the contractor Notwithstanding, they are allowed tocarry forward unrecovered costs to succeeding years Not all countries have cost recoverylimits but it ranges typically between 30%-60% where it exists Also, not all costs arerecoverable while some are taxable However, the most usual allowable costs include;unrecovered costs from previous years, operating costs (this forms the largest part of costrecovery once initial exploration and development costs have been recovered), expensedcapital costs, annual depreciation, depletion and amortization (DD&A), interest on loan(usually restricted), investment credits and decommissioning fund

In PSCs, the contract has two parties, including a government representative and one ormany international oil companies The representative of the host government can be ahead of stage or a national oil company Normally, it is the national oil company When itcomes to foreign contractors, it is usually joint venture rather than an individual firm

Nevertheless, the number of contractors taking part in the contract does not affect itsstructure, because in PSCs, all the members of the joint venture are considered as oneparty Despite the fact that there are a variety of contracts allows the national oil company

to directly participate in the development process, once oil is produced, the contractorsmay have to pay royalty levied on gross production to the government Royaltyconstitutes an immediate cash flow to the government if it has to be paid in cash If it is

an in-kind payment, it provides a cost-free source of crude oil for the domestic market orfor export In the case of cash payment, it is crucial how the value of output isdetermined Assume the PSC stipulates a posted price: If on delivery, the posted price ishigher than the spot (or market) price this is an advantage for the government On theother hand, a posted price below the spot price benefits the contractors Either way,royalty is guaranteed minimum revenue flow from the contractors to the governmentregardless of the profitability of the project This implies that the lower the profitability,the higher is the adverse impact of the royalty on the contractors If the royalty payment

is deductible from income tax liabilities, the government's overall revenue will bereduced Hence, the government is better off if it treats royalties as expenses

In a second step, the operator can recover some of its costs at a pre-specified percentage

of production, the so-called cost oil Most contracts have a cost-oil limit of say 50 percent

of production although contracts with unlimited cost recovery are also in existence Thelevel of cost recovery often varies according to the special characteristics of the field.Marginal deposits for example may need higher cost-oil ceilings in order to guarantee theexpected return on a company's investment If the cost oil is not sufficient to coveroperating costs plus depreciation, depletion, amortization and, where applicable,investment credits and interest, the balance will be carried forward and recovered in thefollowing period

The larger the cost recovery limit is, the longer it takes the government to realize its take.The remainder of production, the profit oil, is then split between National Oil Companyand contractors at an agreed rate, for example 60/40 If we assume that no royalty has to

be paid and cost oil is 60 percent, the profit oil split will be calculated on the basis of theremaining 60 percent of gross production Thus, the NOC would receive 60 percent out

of 60 percent of production, and the FOC is entitled to 40 percent out of 60 percent of

total output The latter then has to pay income tax on its share of profit oil In many cases,tax is paid by the NOC on behalf of the foreign oil companies, or the government forfeitsits right to tax altogether.

In this basic form, the government has three sources of revenue: royalty, tax, and its share

of profit oil Occasionally contracts allow for uplifts as an incentive to the contractors.With an uplift the contractors can recover an additional percentage of capital coststhrough cost oil This reduces the profit oil available to both parties However, uplifts areusually not tax deductible In reality, PSCs have a much larger number of variables.Apart from the already mentioned parameters cost oil, profit oil, royalty and income tax,one will find contract clauses on duration of exploration and exploitation, bonuses,duties, state participation in the operation, work program, pricing, marketing, associatedgas, compensation, and arbitration

1.3 Factors affecting the financial performance of a project

 Political risk: One of the characteristics of the petroleum industry is that it is greatlyinfluenced by political factors Since big oil enterprises are usually national ormultinational petroleum companies, which are owned partly or completely by the State.Therefore, the strategies and policies on energy, economy, and diplomacy of countrieshave huge impacts on the activities of oil and gas companies

 Risk of lacking reserves: Along with demand forecasting and supply evaluation, it isseen that forecast of oil reserves, reserves evaluation, and comparison of the actualextraction rate and the assumed figures for reserves in exploration period, are alsopredictions in the future, and as a result, are very risky Therefore, when implementing aninvestment project on oil and gas, the profitability ratio (IRR, NPV) of the project shouldtypically be higher than other industries (usually about 35%, at least 30%), in order toavoid or offset the risks for large investment Because of its high risks, the profits theseprojects bring, therefore, should be huge to cover risks such as dry wells; the actualreserves are not satisfactory, low extraction rate

 Risk as uncertainty about prices: Crude oil prices depend on whether the situation ofinternational markets is good or bad, which affects the economics feasibility of theprojects These days, oil price volatility is quite complicated because of the influence ofthe European debt crisis and the war-related oil The oil price forecasting in the upcoming

years along with the world's economic recovery not only are challenging but also includeunpredictable risks due to huge volatility In addition, the exchange rate is also a veryimportant factor Because of trading in different currencies, the exchange rates betweencurrencies also affects directly to the oil companies.

 Risk as uncertainty about the costs and budgets: When carrying out the projects,actual costs incurred may be higher or lower than expected budget being calculated,depending on market developments and the abilities of cost control

1.4 Criteria to measure the financial performance of a project

While analyzing the financial performance of a project, the most important part isevaluating its cash flows and discount rate Investing on a project might take many years

In addition, expenditures and revenues arise significantly during those years Net cashflow of the project is the difference between revenues and expenditures in each year ofthe project’s activities This cash flow is used primarily to calculate the cash flow aftertax

1.4.1 Net Present Value

Co= total initial investment costs

A positive net present value indicates that the projected earnings generated by a project orinvestment exceed the anticipated costs Generally, an investment with a positive NPVwill be a profitable one and one with a negative NPV will result in a net loss Thisconcept is the basis for the Net present value rule, which dictates that the onlyinvestments that should be made are those with positive NPV values

 Advantages of Net present value method



Time value of money: The time value of money principle states that a dollar received

today is worth more than one received in the future because of its reinvestmentpotential The net present value method applies this principle by converting aproject’s future cash flows into today’s dollars, which helps you compare projectswith different cash flow patterns

Maximizes company value: While other methods incorporate useful selection criteria,

such as a project’s annual percentage return, a project’s NPV is often more important

to know The higher a project’s NPV, the more it increases your company’s worth

Moreover, the NPV method takes into consideration the cost of capital and the riskinherent in making projections about the future In general, a projection of cash flows

10 years into the future is inherently less certain than cash flows projected next year.Cash flow that are projected further in the future have less impact on the net presentvalue than more predictable cash flows that happen in earlier periods.

 Disadvantages of Net present value method

NPV relies heavily upon multiple assumptions and estimates, so there can be substantialroom for error Estimated factors include investment costs, discount rate and projectedreturns A project may often require unforeseen expenditures to get off the ground ormay require additional expenditure at the project’s end Assuming a cost of capital that

is too low will result in making suboptimal investments Assuming a cost of capitalthat is too high will result in forgoing too many good investments

Discount rates and cash inflow estimates may not inherently account for risk associatedwith the project and may assume the maximum possible cash inflows over aninvestment period This may occur as a means of artificially increasing investorconfidence As such, these factors may need to be adjusted to account for unexpectedcosts or losses or for overly optimistic cash inflow projections

1.4.2 Internal Rate of Return

 Definition:

The internal rate of return is widely used in measuring investment performance Simplystated, IRR for an investment is the percentage rate earned on each dollar invested foreach period it is invested The internal rate of return is a discount rate that makes the netpresent value (NPV) of all cash flows from a particular project equal to zero

 How to calculate:

To calculate IRR using NPV formula, we would set NPV equal to zero and solve for thediscount rate r, which is here the IRR Because of the nature of the formula, however,IRR cannot be calculated analytically, and must instead be calculated either trial-and-error or using software programed to calculate it

According to PetroVietnam’s Decision No 4028/QD-DKVN dated May 12, 2010 on regulations on appraisal of oil and gas projects, IRR min is calculated using the followingformula:

IRRmin = WACC +I + Re +Ro

Generally speaking, the higher a project’s internal rate of return, the more desirable it is

to undertake the project IRR is a uniform for investments of varying types and, as such,IRR can be used to rank multiple prospective projects a firm is considering on a relativeeven basis Assuming the costs of investment are equal among the various projects, theproject with the highest IRR would probably be considered the best and undertaken first

We can think of IRR as the rate of growth a project is expected to generate While theactual rate of return that a given project ends up generating will often differ from itsestimated IRR rate, a project with a substantially higher IRR value than other availableoptions would still provide a much better chance of strong growth One popular use ofIRR is in comparing the profitability of establishing new operations with that ofexpanding old ones

Theoretically, every project having an IRR greater than its cost of capital is considered as

a profitable one, so company might be interested in undertaking such projects.Enterprises have a tendency of establishing a required rate of return (RRR) to estimatethe minimum acceptable return percentage that the investment project being consideredmust earn to be worthwhile Any project with an IRR that exceeds the RRR will likely bedeemed a profitable one, although companies will not necessarily pursue a project on thisbasis alone Rather, they will likely pursue projects with the highest difference betweenIRR and RRR, as chances are these will be the most profitable

 Advantages of IRR method:

time value of money in estimating a project which is a big lacking in accounting rate ofreturn

Simplicity: The most outstanding feature of this method is that it is very easy to

comprehend after the IRR is calculated Managers can interpret it easily, and that is thereason why IRR calculation is preferred until when they come across particularoccasional situations like mutually exclusive projects

 Disadvantages of IRR method:

While IRR is a very popular metric in estimating a project’s profitability, it can bemisleading if used alone Depending on the initial investment costs, a project may have

a low IRR but a high NPV, meaning that while the pace at which the company seesreturns on that project may be slow, the project may also be adding a great deal ofoverall value to the company

A similar issue arises when using IRR to compare projects of different lengths Forinstance, a project of a short duration may have a high IRR, making it appear to be anexcellent investment, but also have a low NPV Conversely, a longer project may have

a low IRR, earning returns slowly and steadily, but may add a large amount of value tothe company over time

Moreover, while analyzing a project using this method, it implicitly assumes that thepositive flows are reinvested at IRR If a project has a low IRR, it will assumereinvestment at low rate of return and on the contrary if the other project has very highIRR, it will assume reinvestment rate at very high return This situation is practicallynot valid At the time you receive those cash flows, having the same level ofinvestment opportunity is rarely possible

1.4.3 Sensitivity analysis

 Definition

We can indicate investment risks by examining the variation of income (depreciation andnet profit) There is a variation of factors which have impact on the income (such asprice, taxation, production quantities…) Sensitivity analysis of a project is to understandhow different values of an independent variable will affect a particular dependentvariable under a given set of assumptions This technique is used within specificboundaries that will depend on one or more input variables, such as the effect thatchanges in interest rates will have a bond’s price

Risks in investment can be determined by the changes in a not-so-good way of one ormany inputs which affect r, Ct, Rt As a result, these changes adversely impact the projectefficiency through some specific indicators, for instant, a fall of NPV or IRR

A project’s efficiency depends on various factors which have been mentioned in theproject’s planning Therefore, we have to evaluate the stability of financial indicatorsillustrating project performance, in specific, to analyze the project’s sensitivity

The actual cash flows achieved in any year will be affected by changes in raw materialcosts and other operating costs and will be very dependent on the sales volume and price

A sensitivity analysis is a way of examining the effects of uncertainties in the forecasts

on the viability of a project

To carry out the analysis, the investment and cash flows are first calculated using whatare considered the most probable values for various factors; this establishes the base casefor analysis Various parameters in the cost model are then adjusted, assuming a range oferrors for each factor in turn This will show how sensitive the cash flows and economiccriteria are to errors in the forecast figures A sensitivity analysis gives some idea of thedegree of risk involved in making judgments on the forecast performance of the project.Sensitivity analysis involves recalculating the NPV or IRR for different values of majorinput variables, where they are varied one at a time Combinations of changes in valuescan also be investigated The results of a sensitivity analysis are usually presented as

tables and plots of an economic criterion such as NPV or %IRR vs the parameter(s)

studied

 Advantages of sensitivity analysis

- Simplicity: There is no complicated theory to understand With most of theconcepts in finance and accounting, we often need to understand anadequate level of knowledge before applying them

- Help managers to get different scenarios: through sensitivity analysis, alarge amount of information is made available to management in the formwhich enables the application of professional judgment when dischargingtheir managerial duties

 Disadvantages of sensitivity analysis

- It does not provide clear cut results The terms optimistic and pessimistic could mean different things to different people

- It fails to focus on the interrelationship between underlying variables For example sales volume may be related to price and cost but we analyse each variable differently

CHAPTER II: SITUATION OF FINANCIAL

PERFORMANCE OF THE PROJECT “PSC 12WEST”

2.1 Introduction of PetroVietnam Exploration Production Corporation

2.1.1 Foundation, History and Development

PetroVietnam Exploration Production Corporation (PVEP) is an enterprise with anoutstanding tradition which plays the leading role in the field of oil and gas explorationand production in PetroVietnam National Group

The formation and development of PVEP associated with the history and development ofthe Vietnam Oil and Gas Industry for over half of a century Starting from Petrovietnam II(PV-II, established in 5/1988) and PetroVietnam I (PV-I, established in 11/1988), PVEPhas undergone several changes of it names and reconstructions along with each of itsdevelopment stage In 1993, PVSC and PVEP were established on the basis ofPetroVietnam and PetroVietnam II’ s reorganization, making a key milestone ofPetroleum Industry in terms of managing exploration production efficiently Also, thecorporation has been participating in production sharing contracts in other nations onbehalf of a contractor They are making every effort to become an outstanding national oilcompany

The establishment of PIDC in 2000 on the basis of PVSC marked a turning point in thedevelopment of today’s PetroVietnam Exploration Production Corporation PIDCfocusing on investment and contributing its capital to various domestic petroleumcontracts, successfully operating important exploitation projects, and at the same time,enhancing investment in exploration and exploitation in other countries with projects firstsigned in Malaysia, Iraq, Algeria had helped PVEP to develop steadily

PetroVietnam Exploration Production Corporation was established on 4/05/2007 in theevent of merging Petroleum Exploration Production Company and PetroVietnam

Investment Development Company to unify production operation and sale activities in thefield of exploration and exploitation of oil and gas in Vietnam and abroad

2.1.2 Organizational Structure and Functions

The mission are to support administration activities, implement and monitor activitiesrelated to administrative management, diplomacy and public relation as well as socialmedia

Figure 2.1 Organizational chart of PVEP

The responsibilities are to restructure the organization, allocate and develop the humanresources by recruiting and training employees, and managing salary, reward anddiscipline policies

The department is responsible for auditing and monitoring accountant activities of thecompany

Formulating financial strategies, Implementing, Allocating, Monitoring and Controllinginvestments of the company

Planning, implementing strategies and managing petroleum projects of the company

Creating development strategies for new petrol projects Researching and selecting newpetroleum projects Evaluating new investment purposes Monitoring and controlling newpetroleum investments of the company

Managing the development and application of information technology and enterpriseresource planning

Managing health and safety policies, environment and technology, innovations andpatents of the company

Managing petroleum source exploration activities of the company

Implementing the company’s petroleum source exploitation and management

Managing the development of petroleum sources, petroleum exploitation, operation andmaintenance activities, including designing, drilling, completing and repairing wells

Researching technically to support the national and international petroleum projects of thecompany

This organizational structure allows PVEP to allocate specific tasks to its employeeseffectively and logically, which maximizes and fully takes advantages of strength andcapabilities of its staff for each function

2.1.3 Petroleum contract in PetroVietnam Exploration Production Corporation

So far, PVEP has been investing in 56 projects in Vietnam and overseas, detailed

by category as follows:

Table 2.1 Petr oleum contracts of PVEP

(Source: PVEP’s internal confidential database)

Inheriting a variety of experiences from its predecessors, PVEP has matured steadily andsucceeded rapidly in exploration and production of oil and gas field Over a 5-year-period, from 2007 to 2012, PVEP has exploited over 40 billion tons of oil and condensate,36.5 billion cubic meters of gas, increasing the oil reservations to 273 million tons Theyalso discovered 27 oil and gas fields, put 16 new fields into production Especially,

PVEP’s revenue during this time reached to over 171 trillion VND, contributed to theState’s Budget approximately 59 trillion VND… In addition, acting as the pioneer ofPetroVietnam in international integration and investment abroad, nowadays, PVEP hasbeen participating in many petroleum contracts in 14 nations The corporation not onlyhave obtained production in several fields such as Cendor, D30 in Malaysia but alsoaccelerate exploitation activities in Venezuela, Algeria, Peru… In a nutshell, these variousachievements that PVEP obtained have greatly contributed to its parent company _ ThePetroVietnam National Group_ in ensuring our national security of energy production,regulating the macroeconomic situation, and protecting sovereignty of the sea islands.

Responding to Foreign Investment Law, which was issued in May 12/1987, In April andMay 1988, Petrovietnam signed 2 petroleum contracts, under the form of PSC, with Shell-PETROFINA and ONGC After that, PVN continues negotiating and signing PSCs withmany oil companies in many countries over the world The contents of the PSC basicallylike the form mentioned in chapter II However, the provisions on the economic part ofthe contract should be noted as follow:

PVEP (on behalf of national oil company) Contractors

Cost recovery

Figue 2.1 Regulation of provisions on economic part of petroleum contract

(Source: PVEP Legal – Edition 1)

Contractors solely bear all risks which occur in exploration phase When commercialdiscovery is available, PetroVietnam has the option to participate in 10% - 20% of thecontract

Contractors have the right to gradually recover all the costs incurred (not includinginterest) for geological exploration phase, development and production phase, from 35% -40% of annual gross production.

The amount of oil remaining after deducting the cost recovery oil is called "profit oil" isdivided by Petrovietnam and the Contractors from a ratio of 65/35 to 80/20, depending onascending petroleum production The amount of oil shared to Petrovietnam includesroyalties and other taxes payable which contractors have to pay under the laws ofVietnam Thus, every year, Vietnam has to give the contractor certifications stated thatthey have completed the obligation of "financing" for the host country Basic model ofsharing profits in PSC is as follows:

Figue 2.2 Model of sharing profit in production sharing contract

(Source: PVEP Legal – Edition 1)

Since 1998, Petrovietnam has applied petroleum contracts in the form of Joint OperatingCompany -JOC Accordingly, Contractors including Petrovietnam Exploration andProduction Company (PVEP) - subsidiary of Petrovietnam and one or more foreignPetroleum Company sign with Petrovietnam petroleum contracts under the form of PSC

The Contractor shall not establish neither Joint Venture company nor consortium, butestablishe "Joint Operating Company".

 JOC has legal status in Vietnam It operates without receiving any profit, only forthe purpose of operating and conducting petroleum activities for the contractors

 PVEP join to the contract right at the beginning, usually 50% but the foreigncontractor bears all the risk remains

 JOC implement the work program and budgets by the approval of ManagementCommittee (composed of an equal number of members of the Contractors andPetrovietnam) JOC also distribute obligations ad rights that the parties shouldfollow

2.2 Project No 12West in Nam Con Son

2.2.1 Government take and contractor take in project no 12.west – Financial

performance

2.2.1.1 Terms and conditions in the production sharing contract offshore block 12West in Nam Con Son basin

a About Nam Con Son Basin

Exploration and Production activities have been started in Nam Con Son basin since1970s of the 20th century There are 26 foreign contractors carrying surveys about nearly

60, 000 km of 2D seismic and 5400 km² of 3D seismic, drilling 78 exploration, appraisaland production wells In addition, 5 fields have been established and 17 oil and gas fieldswere discovered

In 2006, Santos announced an agreement of petroleum exploration from offshoreVietnam Specifically, Santos holds 31.875% stake in Premier Oil Offshore in the form of

a production sharing contract, block 12West with an area of approximately 3447.5 km² ofNam Con Son basin

b PSC block 12W

 Duration of PSC: 25 years for oil since effective date

 Participation rate of PVEP, Premier Oil Vietnam Offshore (POVO), Santos, andDelek are 15%, 28.125%, 31.875%, and 25% respectively