FUNDAMENTALS OF UPSTREAM PETROLEUM

INDUSTRY

BUSINESS AND TECHNICAL PERSPECTIVES

FKK, UiTM

Course Objectives

To provide an overview of petroleum industry in Malaysia

To provide an understanding of upstream petroleum activities from technical and business perspectives

To discuss key issues in upstream petroleum business

To understand petroleum project evaluation process

Contents

1. Introduction to petroleum industry

2. Influencing variables in Petroleum E&P investment

3. Petroleum agreements

4. Political risk

5. Upstream operations

6. Petroleum Industry in Malaysia

7. Malaysian Product sharing contracts

8. Petroleum field development Plan

9. Economic Evaluation of E&P Project

10. Risk Analysis

Systems Context

Organizational System

Political System Economic System

Geological & Geographical system

Petroleum / Petrochemical Industry

Enviromental System

Technological System

Key Players in Petroleum Industry

Multinational Oil Companies (and Independents), MNOC/IOC

National Oil Companies (NOC)

Service Companies

Other Supported Companies

Petroleum Company Objectives

To maximizing and producing return of investments by finding and producing oil and gas reserves at the lowest cost possible and highest possible margin.

Objectives of Petroleum Companies in Upstream Investments

Replace and/or reserve

Maximize profit

Reduce finding and development cost

Increase production rate capability

Diversify reserve area

Upstream Petroleum Activities

Bidding/Acquisition

Exploration

Appraisal and Planning

Development

Production and (Transportation)

Abandonment

Key Questions Asked in Petroleum E&D Investment

Where is the open acreage available for exploration?

What is the best bidding strategy to win the exploration rights? How much does it cost?

What are the fiscal and non-fiscal terms of the agreement?

If the exploration is successful, will it be oil, gas or both be discovered?

What quantities will be found?

Key Questions Asked in Petroleum E&D Investment

Can the field be developed and brought to market economically with the existing technology and the fiscal terms attached to it?

If a new technology is required, will it work and how much will it cost?

What is the existing infrastructure of the location?

What will be the future market for the oil and gas found?

Key Questions Asked in Petroleum E&D Investment

What is the impact of the environmental regulations on the project’s operation and bottom line?

Is there any threat of political events that could negatively impact the project throughout its life?

How should the project be financed?

Is the project in line with the company’s goals, objectives and strategies?

Influencing Factors in Petroleum E&D Investment

Geological potential

Fiscal regimes

Political risk

Oil and gas price forecasts

Technological requirements

Existing infrastructure

Synergy with existing operations

Influencing Factors in Petroleum Investment

Environmental considerations

Geographical locations

Potential exploration & development cost

The company’s short term cash flow

Competitors

Alignments with company’s goals, strategies and objectives

Petroleum Agreements

Roles of Petroleum Agreements

Play a key role in enabling petroleum companies to conduct E&D activities as well as governments to profit from their petroleum resources.

Allocate risks to relevant parties.

Provide incentive for efficient management.

Introduce contracting risks which are risks to non-performing by on or both parties.

Types of Petroleum Agreements

1. Concession system

2. Production sharing contract

3. Service contract (risk and non-risk)

Concessionary System

The oil company receives the right – in exchange for its payment of all costs and specified taxes – To explore, produce and market petroleum.

The company pays a royalty and income tax. Bonuses and minor taxes may be levied as well.

E.g : USA, UK, Norway

Contractual System

The government retains ownership of the petroleum reserves.

Oil companies have the right to receive a share of production or revenues from the sale of oil and gas accordance with the production sharing contract (PSC) or service contract.

Production Sharing Contract

Three basic elements of PSC are cost recovery, a production split between the government and the oil company, and income tax.

PSC is carried out with the government, usually through national oil company (NOC).

Originate in Indonesia where it was first used in agriculture.

E.g. Malaysia, Indonesia

Service Contract

Risk service contract (e.g. Brazil)

Shares the similar elements such as duration of work obligation, but usually it pays the oil company in cash, not crude oil.

Places all risk and investment to the contractor, who provides capital for exploration and production. If no discovery is made, the contract ceases to exist.

If discovery is made the company places the well on stream. Thereafter it may be operated by the state or in some cases, by the contractor.

Capital is reimbursed with interest and a risk fee.

Service Contract

Non-Risk Service Contract.

A simple agreement where the contractor is paid a flat fee for its services.

E.g. Saudi Arabia, Kuwait, Qatar

Ideal Objectives of a Host Government in Designing the Contract

To ensure that the state maintains the major share of revenues from highly profitable projects during periods of high prices or from highly productive new discoveries that can be developed cheaply.

To provide incentives for company to explore and develop small, high cost fields during period of weak product prices.

Host Government Key objectives To maximize economic and non-economic benefits

from petroleum E&P activities.

To attract E&P investments MNOCs.

Elements Petroleum Company needs in Petroleum Agreements Profit in event of success

A secured early cash flow

A balance between risk and reward

Freedom to repatriate profits

Minimum risk

Clear fiscal terms for future developments

Flexible development options

Access to available data

Petroleum Agreement

Contractual terms - terms deal with the non-fiscal aspect of the agreement, for example, the length of the period allowed for exploration, development and exploration phases, and work obligations.

Fiscal terms - deal with timing and distribution of revenue generated by the project between the government and the oil company.

Fiscal Terms

They are the terms that are stipulated in the petroleum agreement contract between the oil company and the host government that directly influence the cash flow of the project.

Among them are royalty, the split of production sharing, signature bonus, production bonus, state participation and research contribution requirements.

Political Risk

Political Risk

“ The probability that the goals of a project will be affected by changes in the political environment. It is the likelihood that political changes will prompt a change in the investment climate regulating a project”

Political Risks Events (Petroleum Specific)

Price increase

Income tax change

Production restriction

Export restriction

Remittance restriction

Foreign exchange control

Currency devaluation

Embargos and boycotts

Reinvestment requirements

Political Risks Events (Petroleum Specific)

Domestic refining and shipping demand

Government to government sales policies

Ancillary demand

Ideological change

Upstream Operations

Three basic elements necessary for a successful prospect

Rocks are capable of being a reservoir.

A structure or trap with a cap rock to form a seal ; and

A source rock which has generated oil or gas to fill trap.

Exploration

Exploration is the process of exploring for potential petroleum reservoirs and the proving of the reserves.

No reserve of petroleum can be accepted or proven until penetrated by an exploration well and fully sampled and tested.

Surveys for Exploration

Seismic surveys - The most usual and informative ways of defining structure in the subsurface and rely in making shockwaves at the surface and measuring the time taken for these waves to be reflected back from the rock layers below.

Gravity and magnetic surveys - are often run in conjunction with seismic profiling using the difference in density between the sedimentary sequence and the basement below to assist with defining subsurface structure.

Exploration

The information obtained by the surveys is converted to depth maps which provide the geoscientists with a three-dimensional understanding of the prospectivity of the area, but drilling a well is the only way to determine whether oil and gas are present.

Appraisal Phase

Once an oil discovery has been made, a program of drilling and testing will be pursued, designed to establish the distribution and continuity of productive zones within the general confines of the reservoir structure, to estimate volume of reserves and to predict reservoir performances.

The objective of the appraisal phase is too acquire at minimum cost enough information to make an informed decision on whether a field development is economically justified.

Types of Information Required to Make a Decision

The volume and nature of hydrocarbons on place i.e. whether gas or oil.

The structure and physical characteristics of the hydrocarbon reservoirs i.e. anticlinal or fault bounded, porous sandstone or fractured limestone, porosity and permeability etc.

The possible range of recovery factors which will lead to an estimate of the recoverable reserves.

The likely producing rate of development wells.

Conceptual Development Proposals

During the appraisal stage, conceptual development proposals are formulated in very broad terms, to be refined later and cast formally into firm development plans.

The conceptual development proposals are concerned with questions such as the number and type of platforms or whether to build a pipeline or load offshore and the shape of the total proposed production system.

Thorough evaluation of the proposals will eliminate a large number as being technically unfeasible, others may be rejected for non-technical reasons, so reducing the possibilities to a small number to be examined in more detail as development plans

Development Plans

When the plan have been examined from all point of view, only few will remain.

These are the technically feasible plan which will now have to stand up to economic evaluation. For this purpose the elements of the plan must be costed and the phasing of expenditure and income determined.

Costs must be broken into capital and revenue items and factors such as taxes and royalties taken into account.

Development Plans

The plans must then be evaluated according to some common yardstick for the purpose of comparison such as Net Present Value and Internal Rate of Return.

Once the economic evaluation have been completed, it is possible to rank the plans in order of economic merit. The final ranking, however may not be the same because of non-quantifiable factor which may be political or environmental, or even technical risk, The ranking may well be subjective and calls for sound judgment and experience.

Development Phase

Development phase is when the project are found to be economically viable to be development and management agrees in principle to proceed.

It includes sufficient technical evaluation and examination of alternatives to propose the engineering design basis for further work.

Development Phase

Once a field is found to be economically viable to develop, a detail Field Development Plan is prepared. The development phase ies usually divided intio following steps: - Engineering/Design Phase - Construction Phases Stage 1 - Offshore-Installation - Production Phase Stage 2

Development Phase

Engineering/Design Phase - The process of system design involves the application of specialized knowledge of structures, petroleum engineering, chemical engineering and costs data which is project specific.

Development Phase

Construction Phase - Steel Jackets -Concrete Gravity Structures - Decks and Modules

An offshore platform is equivalent to a drilling rig, petrochemical processing plant and small town all concentrated to an area the size of a football field.

Development Phase

Offshore Installation Phase -The load out transportation, erection, hookup, and commissioning are carried out. - At the offshore site the equipments are set according to developed procedures and specifications. The hookup and commissioning is done and all systems are checked and proven. A safety inspections is carried out before any system is started up.

Devlopment Drilling

The drilling and production phase cannot start until the construction of the facility is completed.

If separate drilling platform are used the drilling may commence as soon as construction is completed.

Drilling rigs are expensive to operate and a typical 4000 meter offshore well in the North Sea may cost £ 10–15 million compared to

£ 1-2 million for a typical onshore well.

Production Phase

Provides the revenue to turn the huge debts built up prior to the start of production of oil and gas into a profit.

The fluid flowing from a well is nearly always a mixture; either oil with varying amounts of gas; or oil, gas and water ; or gas and water vapor.

The well fluids first flows to one or more separators that allow the components to separate. The gas flows out of the top of the separator to be flared or treated further for sale; the water flows from the bottom and the oil passes to further treatment and storage.

Abandonement

The end of a field’s life is reached, not when the oil or gas stops flowing, but when the revenue received from produced hydrocarbon is not sufficient to cover the operating costs.

Malaysian Petroleum Industry

Historical Facts

Petroleum Development Act (PDA) in 1974 transfers the entire ownership in, and the exclusive rights, powers, liberties and privilege of exploring, exploiting whether onshore and offshore Malaysia, to PETRONAS.

PETRONAS, Malaysia’s National oil company was formed on 17th August, 1974.

National Petroleum Policy

To put good use the petroleum resources of the country.

To enhance the favourable investment climate.

To take advantage of the option increasing revenues by exporting oil and gas.

To ensure Malaysians are adequately represented in the industry.

To effect an optimal social economic pace of exploration of exhaustible petroleum resources and environmental protection.

National Energy Policy

Emphasize the need to provide the nation with adequate and secured energy supplies, towards reducing the dependence on oil, and by developing and alternative source of energy.

National Depletion Policy

To plan for optimal development of major oil fields in order to prolong the production life of nation’s oil resources.

To avoid excessive pre-investment

Exploration Successes

As 1.1.1998, a total 122 oil fields and 208 gas fields have been discovered including 40 oil fields having estimated recovery of less than 8MMSTB

Peninsular Malaysia (64 oil) and (95 gas)

Sarawak (39 oil) and (86 gas)

Sabah (19 oil) and (27 gas)

Mainly in < 200 meters water depth.

Exploration Successes

Success ratio – one oil discovery for every 4.5 exploration wildcat wells drilled (1990-1997)

If gas discoveries included, the success ratio in one in 2.6

Average finding cost is about USD 0.25/Bbl Oil Equivalent (BOE). Relatively low exploration cost.

Reserve

As 1.1.1998 – 7.7 billion STB and 98.7 trillion SCF of recoverable oil and gas, have been discovered in Malaysia.

Malaysia Reserve (1998) - 3.9 BSTB (oil), (67% from 35 fields) - 87 TSCF (gas) (4.6 times larger relative oil in energy terms)

Asia Pacific Reserve - 42 BSTB (oil), 321 TSCF (gas)

World Oil Reserve - 1020 BSTB (oil), 5,086 TSCF (gas)

Malaysia Petroleum Facts (2001)

Oil Reserve : 3.4 billion barrels - World ranking : 27th

Gas reserve : 82.5 trillion cu. ft. -World ranking : 12th

Average oil production : 600,000 bpd

Average gas production : 5.7 billion cu. ft. per day

In the last 5 years, oil reserves have fallen about 15%.

According to PETRONAS, up to 45 exploration wells are expected to be drilled offshore Malaysia from April 2002 to march 2003 (largely unchanged from previous year)

Downstream

Petrochemical related investments to date (2002), RM 69.1 billion where about RM 39.7 billion foreign investments.

Kerteh is the largest concentration of foreign investment in Malaysia.

The Kerteh integrated petrochemical complex covers more than 4000 ha and provides employment to 5700 people.

Downstream

Kerteh facility has the capability to process 2 billion scf of gas per day, where 70% is used to fuel power generation plant.

The gas is then transported through 1700km long Peninsular gas utilization (PGU) pipeline to Singapore, Lumut, Meru, Gurun and Kangar.

The PGU pipeline were built at the cost of RM3 billion.

Concession Agreement (Malaysia)

Between petroleum companies and state governments.

Petroleum companies had exclusive right to explore and produce.

They paid royalty and taxes to government. Profit estimated about 40% of gross revenue.

The concession ceased on April 1, 1975 as a result of Petroleum Development Act.

Petroleum Development Act (PDA), 1974

PETRONAS is the owner of all petroleum resources in Malaysia.

PETRONAS has the right to explore and exploit petroleum in Malaysia.

PETRONAS also controls the carrying on of downstream activities.

The PDA would enable the government, through PETRONAS to ensure the development of petroleum industry inline with the nation’s interests.

MALAYSIAN PRODUCTION SHARING CONCEPT

PETRONAS has the exclusive rights to explore and produce petroleum.

PETRONAS is responsible for management of the petroleum operations and the petroleum company is responsible to PETRONAS for these operations as contractor.

The ownership of oil and gas shall vest in Malaysian government or PETRONAS.

Contractors shall furnish the, necessary risk capital and provide all technical assistance for exploration and production of oil and gas. Such expenditure is recoverable through cost recovery.

MALAYSIAN PRODUCTION SHARING CONCEPT

The remaining production, after deducing cost recovered and royalty, is shared between PETRONAS and contractor.

The ownership of all project-related assets acquired by the Contractor shall pass to PETRONAS.

The laws of Malaysia shall apply to production sharing contract.

Elements Controlled by PETRONAS on PSC

Control of Development and Production Operations

Annual Work Program and Budget and Revisions

Tender and Contract procedures

PSC Account and Audit

Employment and training of Malaysians

Control of Development and Production Operations

Field Development Plan

Notice of operation for drilling and workover activities.

Oil production and gas flaring/venting levels

Surveillance of reservoir and well productions performance.

PETRONAS safety and environmental inspections.

Objectives of Malaysian PSC

To encourage investment in the petroleum industry

To ensure meaningful Malaysian participation in the ownership, management and control in all phases of the petroleum operations.

To secure additional petroleum reserve.

To encourage MNOC to invest in the petroleum industry to support its continued growth.

Major PSC Provisions (1976)

Exploration Period

Development Period

Production Period

Production Sharing of Oil and Gas

Management of Operations

Consultation and Approval

Technology transfer

1976 PSC

Primarily to convert the then existing concession between oil companies and state governments into PSCs.

Concession system was converted to PSC a more equitable partnership.

Exploration period – 5 years

Development period – 4 years

Production period – 15 years

1976 PSC

Non-associated gas, PSC provides a HOLDING period of up to 5 years after the discovery of a GAS field. Within this 5 year period, Contractor has to prepare and agree a development plan with PETRONAS. Production period is 15 years.

Contractors pays all the expenditure required for petroleum operations. The costs can be recovered from oil or gas production.

Production sharing mechanism - 10% as royalty to Government (State and Federal) - Up to 20% is available to contractor to recover its costs (costs oil) and 25% for gas. - Remaining is split 70:30 between PERRONAS and contractor.

1976 PSC

PETRONAS lifts and sells the royalty oil and its profit oil.

Contractor lifts and sells its cost oil and profit oil.

For gas, contractor and PETRONAS sell their shares of gas on a joint basis to a common outlet.

1976 PSC Out of its profit oil or gas, contractor has to make the following

payments : a. Petroleum income tax to Malaysian government – 45% of

the taxable income. b. Export duty to Malaysian Government – 20% Profit Oil

portion exported, c. Research Cess to PETRONAS – 0.5 % cost oil plus profit oil d. Export Duty to Malaysian Government – 20% profit oil,

portions exported. e. Discovery Bonus to PETRONAS – RM2.5 million before first

production. f. Production Bonus – RM 5.0 million when production reached

50 Kb/d (or, each multiple).per quarter g. Supplemental payment to PETRONAS – 70% of incremental

Profit Oil revenue when Oil base price ( Which escalates 5%

per year from 1975 Base Price of USD 12.71/bbl)

Management of Operations

PETRONAS is responsible for the overall management of the petroleum resources of Malaysia.

Contractor is responsible for the necessary exploration, development and production activities, as an independent contractor to PETRONAS.

Consultation and Approvals

In the course of implementing the PSC, numerous meetings, discussions and communications take place at the various levels between PETRONAS and Contractor.

Each year Contractor is required to prepare a work program and budget describing all aspects of the proposed operations in the following year.

Transfer of Technology

Malaysian staff.

Provide development and training programs for its Malaysian staff.

Training programs for PETRONAS staffs.

1985 PSC

To attract more E&D investments during early 1980s.

Offered better terms to contractors.

Specified minimum participations of Carigali.

Cost oil ceiling increase from 20% to 50%.

Cost gas ceiling increase from 25% to 60%

Sliding scale on profit split for both oil and gas. - First 10,000 bbl/d – 50:50, from 10,001 to 20,000 bbl/d –

60:40, above 20,000 bbl/d – 70:30 all in favor of PETRONAS.

1985 PSC

Profit oil split 70:30 beyond 50 million bbls cumulative production.

Profit gas split 50:50 up to 2 trillion cu. ft. of gas production. Beyond this the split is 70:30 in favor of PETRONAS.

Carigali to have minimum of 15% carried interest, with participation option on commercial discoveries.

PSC BASE price – USD 25/bbl in 1988.

Export duty is 25% of profit oil barrels.

1985 PSC

28 PSCs signed.

Minimum investment commitment of USD 368 million

125 exploratory wells.

Deepwater PSCs

Introduced in 1993

Based on 1985 PSC

Improvement on cost recovery, profit split and the exploration, development and production periods to reflect the higher costs, higher risks and technology required in the deepwater operations.

Deepwater PSCs

Lead time - Exploration Period – 7 years - Development Period – 6 years - Production Period – 25 years

Cost oil ceiling 75%

Cost gas ceiling 60%

Deepwater PSCs

Two type of deepwater contracts : - 200 to 1000 meter water depths. - more than 1000 meter water depths

As Oct. 1999, 5 blocks taken by Esso, Shell (3), and Murphy

Additional players, Conoco and Amerada Hess (Block F, offshore Sarawak).

Revenue Over Cost PSCs

Introduced in 1997.

Profitability based fiscal regime.

To further stimulate exploration activities.

To provide incentives to develop smaller discoveries.

To promote use of cost effective new technology in E&D.

To balance the softening oil price and increasing operating costs.

Revenue Over Cost PSCs

Built in self adjustment mechanism for the changing price and costs environments.

Allows contractors to have a larger share of revenue of a project.

Gives contractor a quicker cashflow at the beginning of the period and increase the economic feasibility of developing marginal/small fields of 30-50 million barrels of reserve.

Key items in PSC fiscal terms

Royalty

Cost Recovery

Profit Oil and Gas

Export Duty

Payment for PETRONAS