After a long hiatus we are now returning to the series on oilfield economics.
Discounted cash flow return on investment (DCFROI) also referred to as discounted cash flow rate-of-return (DCFROR) or Internal Rate of Return (IRR) is defined as the discount rate at which the NPV is zero. It is very attractive to decision makers because of its instinctive similarity to the interest rate at a bank. Oil and gas property cash flows are essentially dissimilar to putting money in a bank and receiving small interest payments that are then reinvested over time. DCFROI has several other drawbacks; however, it is one of the most popular investment evaluation tools, particularly for investment efficiency. Let us return to project C in the prior post and continue to use ANEP discounting but vary the discount rate from 0 to 50%.
Illustration of calculating DCFROR
Values above about 25% for the discount rate result in negative values for NPV. Values less than 25% have a positive NPV. Using trial and error, the discount rate that sets the NPV to 0 is 25.35%.
Project D has the identical DCFROI to project C because all cash flows are just five times larger. Project A has a DCFROI of 23.38% and project B has the lowest DCFROI at 18.37%. The “best” project will (in general) depend on the company’s cost of capital.
Now examine the cash flows from project C. If you were able to invest money in a bank at 25.35%, would you expect your cash flows to look anything like those in project C? The decision maker who uses DCFROR to rank projects will need to fully understand its strength and weaknesses.
There are certain types of cash flow schedules in which more than one discount rate results in a zero value for NPV. Examples of such cases include rate acceleration incremental evaluations and cases requiring large investments sometime during the life of the project. A non-unique solution may occur whenever there is more than one change of sign in the cumulative cash flow. In other words, if the cumulative cash flow starts out negative, turns positive and turns negative again (perhaps turning positive again later), a non-unique solution or multiple rates-of-return solution is possible. The incremental cash flow from evaluating an acceleration project is typical of such a project. Because some companies utilize DCFROI in comparing alternatives, reporting only one of the values where the discount rate yields a zero NPV would be misleading.
The SPEE conducted a study based on comparison of various economic evaluation software at the SPEE Petroleum Economics Software Symposium 2000 held March 2, 2000 in Houston, Texas. Some software products reported only one value, others printed both. Some issued cautions. The SPEE “Recommended Evaluation Practice #9 – Reporting Multiple Rates of Return” recommends the following evaluation practice.
In cases where multiple rates of return exist, the reported economic summary should alert the user of the report that multiple rates of return exist (in lieu of printing a single rate of return). In these cases the summary output should also refer the reader to the present value profile data. A suggested presentation for such an alert on the summary output might be as follows:
IRR: Multiple rates of return may exist, see present value profile plot
DCFROI has other problems as a tool for ranking projects. It cannot be calculated in the following situations:
a) Cash flows are all negative (dry hole cases, leasing costs, projects that fail to generate any positive cash flows.)
b) Cash flows are all positive (farmout of a lease which becomes a producing property, situations without investments involved that generate production, etc.)
c) Cash flows are inadequate to achieve simple payout. If the cash flows do not recover the investment cost, they fail to generate a positive DCFROI. (a well that fails to recover its drilling and completion expenses prior to abandonment)
Another complaint that many people express about DCFROI is what is purported to be the inherent assumption that it assumes all cash flows are reinvested at the same discount rate as the DCFROI rate. This is based on the fact that all cash flows are discounted at the same rate. In this argument, DCFROI is overly optimistic for high rates of return because when the oil company invests a certain amount of money into a project with a high DCFROI the cash flows that are returned to the company are reinvested at an arguably lower rate-of-return. This confusion comes about primarily because many people view DCFROI as somehow being equivalent to a bank interest rate. If an oil company chooses project C in our prior example, it is not the same thing as investing $1000 at 25.35% interest. The company in project C invested $1000 and returned $1500 in three years. Had they invested $1000 in a bank at 25.35% they would have $1969 at the end of three years. Of course the company didn’t leave the money it generated during the first three years in a sock in their office desk. But what return they achieved on reinvested funds is irrelevant unless you are trying to estimate future wealth of the corporation rather than the marginal contribution of the project.
This argument forms much of the basis for the use of Return on Discounted Cash Outlays (RODCO). On the other side of this argument is the common sense analogy to interest rates. If the bank loans someone $1000 at 10% interest rate, the return of interest and principal discounted at 10% will result in a zero NPV as long as the discounting procedures match. It doesn’t matter what the bank or the borrower does with other investments, the specific transaction has a 10% DCFROI. The key issue to remember is that DCFROI is not the equivalent of a bank interest rate and should generally be used to compare similar projects for investment efficiency.
Very high values of DCFROI can be obtained. When values are calculated above 100% per year it is recommended to simply report 100%+ instead of the high values. DCFROI is a more realistic measure of financial attractiveness than NTIR or payout, primarily because it incorporates the time value of money. It is an excellent measure of capital efficiency to compare alternative projects with comparable life spans and cash flow patterns. It cannot be calculated for certain types of projects and can lead to multiple solutions in others.
Payout fans will recognize that payout can also be determined using discounted cash flows. A discounted payout basically answers the question “When will I have a positive NPV at a given discount rate?” It suffers from all of the weaknesses of payout other than the fact that payout is on undiscounted cash flows. It has an additional drawback in that it is less familiar. Payout was simple; discounted payout requires a specific discount rate and specific discounting approach just as does NPV. Discounted payout is not widely used.