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ENGINEERING ECONOMICS OF
OIL & GAS OPERATIONS
Chapter 3 INFLATION &
ESCALATION
BY: H U S N A H AYAT I
D E PA RT M E N T O F O I L A N D G A S E N G I N E E R I N G
FA C U LT Y O F C H E M I C A L E N G I N E E R I N G
UITM SHAH ALAM
Definition
Project : an investment opportunity generating cash flows over time
Cash Flow: the movement of money (in or out) of a project
Interest: used to move money through time for comparisons. The rent for loaned money
Cash Flow Diagram: Describes type, magnitude and timing of cash flows over some horizon
Principal: P : capital
Amount invested or loaned
Interest Rate: i
Rental charge for money defined as a percentage of principal per time period
Compounding Period
Defines how often interest is calculated (may not be paid, however)
FIXED INTEREST
Fixed Interest - Does not take into account factor of time. Value is constant
regardless of long or short period.
For example a 10% fixed interest on $100 will generate $10 regardless of
when it will payout. Interest of this nature has not determinate rate and thus
a loan of $100 for 18 months would be more beneficial than a loan of $100
for 6 months. The loaner will still have to pay out $10 regardless.
SIMPLE INTEREST
Simple Interest is defined as a constant proportion of the initial amount per
period:
An
Ao
COMPOUND INTEREST
Compound Interest is defined as proportion of the accumulated debt or
investment. The interest charged or paid in the current year includes a
proportion of interest incurred in previous years.
COMPOUND INTEREST
For example: An Investment of $100k at 10% interest for 10 years
Year
Capital
Interest
Payback
$100k
$110k
(0.1*$100
k)
$110k
$121k
(0.1*$110
k)
$121k
$133k
(0.1*$121
k)
$133k
(0.1*$133
k)
$146.3k
10
$259.4k
= Nominal interest
EFFECTIVE RATE
The Effective Interest Rate, Effective Annual Interest Rate, Annual
Equivalent Rate (AER) or simply Effective Rate is the interest rate
on a loan or financial product restated from the nominal interest
rate as an interest rate with annual compound interest.
It is a rate used as standard, by which to compare different
compounding schemes. The effective annual interest rate for an
investment is the rate of interest, which, if applied once per year
would generate the same growth as that investment.
EFFECTIVE RATE
Let i = Effective Annual Interest
Compare the two compounding equations:
Compound Interest
Compound Interest with Nominal Growth
Thus,
EFFECTIVE RATE
Example:
You are offered a credit card and the interest rate on the card is
1.5% per month.
The nominal rate is 12 x 1.5 % = 18% per year.
Effective interest rate;
= (1 + 18%/12)12 - 1
= (1 + 0.015)12 - 1
= (1.015)12 - 1
= 0.1956 = 19.56%
* For the same nominal rate, what is the effective interest rate for daily
compounding?
DISCOUNTING
Discounting is the inverse of compounding.
An
= Future value
Ao
= Present value
= Discount rate
= Duration
Application of discounting
1. Computation of the present value of a single or a series of future cash
flow.
2.Screening and ranking of investments on the basis of present value.
ANNUITY
Annuity
RANKING INVESTMENTS
An investor has $1250 with these following investment options:
Option 1 : Deposit the money in a bank account to receive a
compound interest of 5%.
Investment value received after 10 years is,
A10 = 1250 (1.05)10 = $2036
Option 2 : Invest the money in a small company, which will pay
$3500 after
10 years.
Investment value received after 10 years is,
Lump sum payment of $3500
RANKING INVESTMENTS
Option 3 :
Use the money to buy a pension which will pay out $250 per
year for 10 years.
The money can be invested in the bank with
Year
Cash Flow
Compound Factor
Terminal Value
compound
interest
5%.
2
250
(1+0.05)9
387.83
250
(1+0.05)8
369.36
250
(1+0.05)7
351.78
250
(1+0.05)6
335.02
250
(1+0.05)5
319.07
250
(1+0.05)4
303.88
250
(1+0.05)3
289.41
250
(1+0.05)2
275.63
10
250
(1+0.05)1
262.50
11
250
(1+0.05)0
250.00
Total
3144.47
RANKING INVESTMENTS
Evaluate the present value of Option 2 and Option 3 for discount rate at 5%.
Evaluate the investment options for interest rate of 10%.
MOD VS RT
Money of the Day (MOD), also known as "Current Dollar", "As Spent Dollar",
"Escalated Dollar". MOD Dollar is also used in budgeting purposes. The
actual economic calculation is carried out in MOD Dollars.
Real Term Dollar (RT), is the "Constant Dollar in discussing about income.
Reference year must be specified such as RT 2002, RT 2003, etc. In
economic analysis, RT Dollars is used to report profitability.
n : numbers of period
I : interest per perriod
Converting RT to MOD:
Value (MOD) t + n = Value (RT)t *
( 1+ i )n
Value (RT)
Value (MOD)
ESCALATION
Future costs or prices are commonly modelled as a compounded
series.
Example :
The current oil price is $100/bbl. Calculate the oil price
after 10 years if
prices are rising at 3% per year.
= $100/bbl * (1 + 0.03)10 = $134.39/bbl
INFLATION
The prices of most goods and services change over time. Inflation is the
rate at which the general level of prices for goods and services is rising,
and, subsequently, purchasing power is falling. Central banks attempt to
stop severe inflation, along with severe deflation, in an attempt to keep the
excessive growth of prices to a minimum
As inflation rises, every dollar will buy a smaller percentage of a good. For
example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02
in a year.
Most countries' central banks will try to sustain an inflation rate of 2-3%
INFLATION
There are several variations on inflation:
Deflation is when the general level of prices is falling. This is the opposite of inflation.
Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the
breakdown of a nation's monetary system. One of the most notable examples of
hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month!
Stagflation is the combination of high unemployment and economic stagnation with
inflation. This happened in industrialized countries during the 1970s, when a bad
economy was combined with OPEC raising oil prices.
INFLATION MEASUREMENT
Commodi
ty
Food
500
1.00
500
1.25
625
Clothing
200
5.00
1000
6.00
1200
Fuel
50
2.00
100
3.00
1500
Total
2002
1600
2012
1975
TUTORIAL
1 5 (WHITEBOARD)
6. A company has borrowed an amount of MYR30 MM from the bank in 2014. The money
will be released in three (3) phases in January 2015, January 2016, and January 2017.
Repayment for the loan has to be made in four consecutive years, from January 2019 until
January 2022. If the interest rate is fixed at 12% per annum, calculate the annual
repayment.
7. Determine the interest rate, i, if an amount of MYR 1000 was invested in 2004 and
generate, RM 2158.93 in 2014.
8. The Retail Price Index increased from 440 to 625.7 in the period of 10 years. Analyze
the period of the time for purchasing power of the investment to double at the annual
compounded rate in (7).