Price Escalation Issues
Posted by D Nathan Meehan February 18, 2011

Price Escalation and Constant Price Cases

Changing product prices for oil and gas are a fact that is now ingrained in the thought processes of evaluators. Price forecasting can be based on many approaches ranging from fundamental supply and demand predictions through trend analysis. No method has a stellar track record over a significant time period. One approach to dealing with such uncertainty is the so called “constant price” approach. This approach is in fact a forecast, and in many cases it may be as good as any other. Economic evaluations which include the impact of inflation on the various costs and revenues associated with a project or business opportunity are more common than are constant price cases.

Most large corporations use an official corporate forecast for consistency among economic evaluations, typically with a maximum price or a fixed number of years of escalations. Some companies include both an escalated price case and a fixed price case to illustrate the impact of price escalation. In constant price cases, escalators for operating costs are also usually set to zero with the only increases in operating costs due to (for example) increased water production. Constant prices do generally reflect contractual changes in prices or costs. Many constant price cases are evaluated at WACOC or corporate discount rate minus the inflation rate as the “constant price” discount rate.  Some evaluations such as SEC reserve evaluations require the use of constant price cases.

SPEE Guidelines for Escalations

The SPEE guidelines for reporting price escalations can be found on their website; however, the focus of these guidelines deals with publishing evaluations. The important factor is a consistent application of escalation approaches and clear communication about the assumptions. Some excerpts of the relevant SPEE recommendations include:

In keeping with general practice, the application of escalation factors should be assumed to start with the second time period. The application of escalation factors should be based on the size of the smallest time period being evaluated. The most commonly encountered time period sizes are monthly and annual, although quarterly or semi-annual time periods may be encountered.

If monthly cash flows are used, escalation should take place in a “stair step” fashion on a monthly basis. Thus if prices are assumed to increase at 6% per year, the monthly increase would be based on an effective annual rate of 6% per year with prices increasing every month.

If annual cash flows are used, escalation should take place in a “stair step” fashion on an annual basis. Thus, if prices are assumed to increase 6% per year, the price is held constant at the escalated rate for the entire year, then increased 6% for the following year1.

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D Nathan Meehan