The effects of inflation on evaluation of petroleum producing properties



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Currently, traditional investment evaluation techniques are failing to give a true indication of the actual monetary return that capital projects generate. This is due to the impact of inflation on the buying power of the dollar and must be recognized if potentially unsuccessful ventures are to be eliminated from consideration in investment decisions. With this inflationary condition in existence, traditional engineering economy formulae have been analyzed and new formulae developed to recognize the importance of evaluating investment options in terms of the purchasing power of future revenues. These formulae offer tools to evaluate the true rate of return of capital projects and to analyze projects in terms of dollars of constant purchasing power. The application of these formulae is centered around petroleum decline curve analysis and the general evaluation of producing properties. Since petroleum production revenues are the source for future production and exploration funding, the accurate profitability measurement needs of the industry are obvious. In including assumptions regarding future inflation in the evaluation of producing properties, it has been shown that traditional evaluation techniques often point to incorrect selection and evaluation of investment options. That is, evaluations not considering inflation can overstate future revenues thus biasing investment selection to long payout projects which produce little, if any, increase in real wealth. As a solution to the measurement of the inflationary impact, it has been shown that reliable estimates of a specifically indexed inflation rate must be included in analyses of producing properties. In this manner, the maximization of wealth can be sustained by the rejection of nonprofitable production investments and the recognition and selection of investments which do not magnify the cost and price consequences of inflation.