Cashflow Modelling for the
Energy Industry (2)
James Henderson
March 2023
The Economics of Energy Corporations (2)
Outline of the course
Overall objective – understand how senior management use economicmodels to
make investmentdecisions
1. Introduction to key themes in the global energy market
2. Introduction to financial modelling as a managementtool
1. Understanding some key concepts
3. Starting two models for an oil and a gas field – revenues and prices
4. Inputting the costs – capital expenditure
5. Operating costs and paying the government
6. A power plant – a buyer and seller of energy
7. Calculating a discounted cashflow
1. Why is it important
2. How is it used to make decisions
8. Testing the investment decisions: running some numbers under different
assumptions
9. Answering your questions
The Question
• Value an energy asset given specific
assumptions
– Examples of an oil and gas field and a power
station
• Test the sensitivity of the model
• Provide an investment conclusionfor senior
management
title• Detailed
breakdown of
company operating
and financial
performance
• Investmentanalysts
are responsible for
asking fundamental
questions of senior
management
• There is pressure to
perform across a
broad range of
metrics
• A “Sell”
recommendation
can have big
implications
Bad news!
Share price determines market valuation
• Share price multiplied by number of shares in issue = market value
• Market value divided by profits gives “price to earnings ratio”
• Potential value can be derived by using multiples and future profit
forecasts
BP Share Price over past 12 months
Comparison with Peer Groups
A typical spreadsheet summary of a cashflow model
Time Value of Money
• Money available at the present time is worth more than
the same amount in the future due to its potential earning
capacity.
• This core principle of finance holds that, provided money can earn
interest, any amount of money is worth more the sooner it is
received
• Equally, money available now can buy more than a similar amount
of money available in the future because inflation erodes the
value of money over time
Time Value of Money Example
• If you had $10,000 today, you could earn interest on it
• Its future value is $10,000 x (1 + interest rate)No. of years
• If interest rate is 5%, then $10,000 in 3 years is worth
– $10,000 x (1+.05)3 = $11,576
• As a result, $10,000 in 3 years is not worth $10,000 now
– $10,000 / (1+.05)3 = $8,638
• Let’s look at an example
Impact of inflation
• I have $100
• A bar of chocolate costs $1
• Inflation is 5%
• In Year 1 I can buy 100 bars of
chocolate
• In Year 2 the cost of a bar of
chocolate has risen to $1.05
Money in
wallet
Cost of
chocolate
Chocolate
bars
Year 1 100 1.05 95
Year 2 100 1.10 91
Year3 100 1.16 86
Year 4 100 1.22 82
Year 5 100 1.28 78
Year 6 100 1.34 75
Inflation and interest rates
• I have $500
• Inflation is running at 4% per annum, and the interest rate is 5%
• I want to purchase printer ink, which costs $5 per cartridge
• How many fewer cartridges can I buy in 7 years time than now if I
just keep my $500 in my wallet?
• If I put my $500 in an interest bearing account, how many
cartridges could I buy in 4 years time?
Real and Nominal Figures
• Nominal cashflows include the impact of inflation
• They are called Money of the Day (MoD) because they reflect the
actual worth in a certain year
• If we were forecasting the cost of a project, for example, we
would need to add inflation to each year as we moved across the
time horizon
• This is relevant for multi-year developments when parts are being
purchased over time
Nominal Costs Example
• Costs will rise over time because of inflation (in this example 5%
per annum)
50
60
70
80
90
100
110
120
Year 1 Year 2 Year 3
Cost of plant (today) Cost of plant (MoD)
Year 1 Year 2 Year 3 Total
Cost of plant (today) 100 100 100 300
Cost of plant (MoD) 100 105 110 315
Using “Real” figures makes life easier
• When making assumptions in nominal, every figure needs to take
an inflation assumption into account
• This can make things very complex
• To make life easier, we can just assume that our model is in
“today’s money” – otherwise known as “in real terms”
• Generally, we would define all the figures as being in (e.g.)
US$2020
• All figures in the cashflow will be lower as a result, and so it is
important to define how the model is considering inflation
Real and Nominal Figures
• Question 1
– The cost of a plant is $500mm spentequally over 5 years in real (2022)
terms
– Inflation throughout the period is forecast to be 2.5% per annum
– What is the expenditure on the plant in nominal terms in Year 5 and what
is the total nominal cost?
• Question 2
– We are assuming that the oil price is $30 in real (2022)terms
– Inflation is assumed to be 2% per annum
– What is the real oil price in Year 5?
– What is the nominal price in Year 5?
Discounted Cashflow
• In Year 0 (today), I decide to invest $30mm over 3 years in a plant
that will run for 7 years, generating $20mm per year
• The plant will then be dumped
• What is the value (worth) of this investment in today’s terms?
-15
-10
-5
0
5
10
15
20
25
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Cashflow(US$)
A Simple Cashflow
The DCF Calculation as a foundation
• Management thought process is encapsulated in the DCF model
– Key assumptions include price, cost, tax, long-term outlook, short-term cashflow and the
value of money
• Management mustensure at all times that the combined value of their assets
remains NPV positive, and should aim to maximisethe return on their assets
Discounted CashflowExample
• The further away that money is earned (or spent) the less worth (value) it has
today
• We discount future cashflow by a factor reflecting the other options we had for
using the initial funds
• If the total sum of negative and positive cashflow is positive then the
investmentis worth making
-15
-10
-5
0
5
10
15
20
25
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Cashflow Discounted Cashflow
Today Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Cashflow 0 -10 -10 -10 20 20 20 20 20 20 20
Discount factor 1 1.05 1.10 1.16 1.22 1.28 1.34 1.41 1.48 1.55 1.63
Discounted Cashflow 0 -9.52 -9.07 -8.64 16.45 15.67 14.92 14.21 13.54 12.89 12.28
Total Value 72.74
A Good Explanationfrom Harvard
• https://hbr.org/2014/11/a-refresher-on-net-present-value
Functionality in Excel
• The NPV function in
Excel makes life very
easy
• =NPV(discountrate,
range of net cashflow)
Real vs Nominal Cashflowand NPV
• To make our lives easier, all our modelling will be carried out in
real terms
• Our expectations of return should therefore be lower
0
20
40
60
80
100
120
140
2019 2020 2021 2022 2023
US$mm
Cost of Plant (US$2018) Cost of Plant (MoD)
2019 2020 2021 2022 2023
Cost of Plant (US$2018) 100 100 100 100 100
Cost of Plant (MoD) 100 105 110 116 122
NPV (Real) 433
NPV (MoD) 476
Construct a simple cashflowmodel
• All figures in US$2022 (Real)
• Capital costs- $600 over 3 years
• Revenues – start in year 4, $100 per year from year 4 to year 20
• Operating costs- $20 per year starting in year 4 until end of
operations
• Discount rate 10%