Shareholders entrust companies to invest their money prudently. By owning shares, shareholders own companies and they own the funds generated and invested by those companies. To ensure that the funds generated by a company are invested wisely, companies perform economic evaluations of projects and business costs. Economic evaluations of projects confirm that proposed investments in projects will be profitable if forecasts of production, revenues and costs materialize as forecast. Economic evaluations of business costs ensure that reasonable prices are paid for the purchase of assets, for the use of assets owned by others, for the services provided by others, and for the funds provided by others. Undertaking economic evaluations is a crucial function performed by companies on behalf of their shareholders.
The purpose of this guide is to describe the principles and methodologies employed by companies to perform economic evaluations. This begins with a description of the basic concepts and measurements used in the economic evaluation of projects and transitions to leases, tariffs and acquisitions once basic concepts, measurements and methodologies are established.
I worked in the Canadian oil and gas industry for 40 years and served as a petroleum economist for most of that time until retiring. I performed and supervised a multitude of project economic evaluations for eastern Canada offshore oil development, central Canada petroleum refining and marketing, western Canada oil and gas, Alberta oil sands, the Canadian arctic, mid-western USA, the North Sea, North Africa and the Middle East. These economic evaluations included the appraisals of deep water oil and gas exploration prospects, the development of billion dollar offshore oil-platform projects, the determination of purchase prices for major assets and energy companies, the determination of pipeline tolls, the evaluation of time charter arrangements for marine oil tankers, the leasing of equipment, vehicles, commercial property and aircraft, the evaluation of liquefied natural gas (LNG) projects, optimization of refinery production costs and countless other applications. I instructed numerous in-house economic evaluation workshops in Canada as well as several internationally. I also participated in many negotiating and lobbying sessions with energy companies, governments and business associations on behalf of my employer.
I was approached by individuals many times during my career inquiring as to whether I could recommend a book that describes the essentials of economic evaluations performed by business practitioners. These individuals included workshop participants, project economists, corporate managers and contract lawyers. Unfortunately, I was never able to recommend a book to these individuals for the simple reason that I had not come across such a book. I promised myself that when I retired I would write a business guide that describes the fundamentals of economic evaluations of projects and other business applications. Having instructed and mentored numerous individuals over the years, I already had a good idea of how I would structure the guide and the forms of explanations that I would employ.
Properly assessing the economic profitability of investing capital in a project requires that several concepts be understood. For example, what is a project? What are project cash flows? Which costs in project cash flows need to be restructured and why? What is capital? What are the sources of capital? What is the cost of capital? What does economic profitability mean? How is economic profitability created within the project cash flows? What are the economic measures used to assess economic profitability? What are their characteristics, strengths and weaknesses? All of these questions and more are addressed in this guide.
Several categories of economic evaluations are well known to industry. By far the most common category is assessing the economic profitability of investing capital to develop a project, but there are other categories as well. For example, determining if an asset should be purchased or leased; determining the appropriate tariff for a pipeline or processing plant; determining an appropriate purchase price for a producing asset or entire corporation; and determining whether project component inventory should be kept or sold. As these applications are often encountered in business, I have dedicated several chapters to these topics. The chapters on tariffs and acquisitions warrant special mention. Simplified descriptions of these two topics are not easily located in current financial literature because of their specialized nature. I have drawn on my career experiences to describe these applications in easy-to-understand terms beginning with first principles. While my economic background is in the oil and gas industry, I have written this guide as a generic guide applicable to all industries.
The arithmetic calculations required to determine economic profitability are carefully described in this guide and are illustrated using simplified numeric examples, but this in itself is not sufficient. Describing arithmetic calculations does not explain meanings. To explain meanings effectively, I have employed creative illustrations and analogies extensively throughout this guide. For example, the concept of economic profit is carefully developed and utilized to explain the concept of net present value in a manner that I have not seen used in other financial books. Analogies are drawn to the common bank savings account to illustrate the meaning of certain economic measures. The difficult concept of cost of capital is explained by treating cost of capital as a cash fee paid by a project to its parent company. This cash fee is divided into three cash components, one to pay debt interest, one to pay stock dividends, and one to be retained by the parent company to increase the value of its shares and hopefully its share price by an amount specified by financial theory. This approach to explaining cost of capital and the other creative analogies used to explain economic concepts differentiate this guide from current financial books. Explanations are supported by diagrams, point form summaries, simplified numeric examples, and bar charts in 278 figures.
Project economists, corporate managers, business students and contract lawyers come to mind as the primary readers who will benefit from reading this guide. Even so, I have written this guide in a manner to encourage anyone with the slightest interest in learning about the economic evaluation of projects and business costs to read this guide, even if they have no background in this subject matter.
This guide is divided into two parts. Part A provides high level explanations of all concepts and methodologies and utilizes numeric illustrations at summary levels to illustrate the methodologies being applied. Part B describes in more detail the calculations and concepts used to derive the economic results presented in Part A. With this construct, readers can choose to limit their reading to Part A to obtain a general understanding of key concepts and methodologies or readers can choose to dig into the numeric details and explanations by reading Part B as well to develop a more comprehensive understanding.
It took my full 40 years of industry experience to develop the level of understanding that I now possess regarding economic evaluations. My undergraduate degree in mathematics and master’s degree in business administration facilitated this learning, but there is no substitute for the practical experience I obtained over the years. Even as I wrote this guide, I continued to learn because there were subtleties underlying certain financial concepts that I had not fully appreciated until I found myself having to explain these concepts in words and illustrate them numerically. Having now completed this guide, I can relax with the thought that the expertise I acquired over the years will not retire with me but will be passed on through these pages.
As a closing comment I will unabashedly state that I wish this guide had been handed to me many years ago when I began my career as a petroleum economist. It quite literally would have saved me months of unnecessary work in trying to figure things out for myself or redoing analysis to reflect more prudent approaches because I lacked the benefit of a good reference guide.