Overview
Well economics analysis evaluates the financial viability of drilling and completing oil and gas wells. The key metrics are Net Present Value (NPV), Internal Rate of Return (IRR), payout period, and breakeven commodity price. These metrics drive investment decisions for individual wells, development programs, and A&D (acquisition and divestiture) transactions.
Theory
Cash flow analysis combines production forecasts (from decline curves) with commodity prices, operating costs, royalties, taxes, and capital expenditures to generate a time series of net cash flows. The time value of money is then applied through discounting to compute NPV.
Formulas
Net Revenue
Revenue_month = (q_oil * Price_oil * (1 - oil_diff) + q_gas * Price_gas + q_NGL * Price_NGL) * NRI
where NRI = Net Revenue Interest = WI * (1 - royalty rate).
Net Cash Flow (Monthly)
NCF = Revenue - LOE - Variable_OPEX - Taxes - CAPEX * WI
Taxes = (Revenue - LOE) * Tax_rate (simplified)
Cumulative Cash Flow
CCF(t) = Σ NCF(1..t) - CAPEX (at t=0)
Net Present Value (NPV)
NPV = Σ [NCF_t / (1 + r/12)^t] - CAPEX
where r = annual discount rate, t = month number.
Internal Rate of Return (IRR)
IRR is the discount rate r* that makes NPV = 0:
0 = Σ [NCF_t / (1 + r*/12)^t] - CAPEX
Solved iteratively (bisection or Newton-Raphson).
Payout Period
Payout = month t where CCF(t) first becomes ≥ 0
Breakeven Price
The commodity price at which NPV = 0 (solved iteratively):
NPV(P_breakeven) = 0
Production Forecast (Arps Decline)
q(t) = qi / (1 + b * Di * t)^(1/b)
EUR (Estimated Ultimate Recovery)
EUR = Σ q(t) * Δt (summed until economic limit)
Economic limit: when monthly NCF < 0.
Profitability Index (PI)
PI = NPV / CAPEX
PI > 1 indicates value creation.
Worked Example
Given: qi = 300 bbl/d, Di = 8%/month, b = 0.8, oil price = $70/bbl, CAPEX = $5M, LOE = $15,000/month, NRI = 0.75, discount rate = 10%.
Month 1:
q = 300 / (1 + 0.8*0.08*1)^(1/0.8) = 300 / 1.064^1.25 = 300 / 1.080 = 277.8 bbl/d
Oil production = 277.8 * 30.4 = 8,445 bbl
Revenue = 8,445 * 70 * 0.75 = $443,363
NCF = 443,363 - 15,000 - 443,363*0.07 (sev tax) = $397,327
NPV (simplified, 60 months):
Cumulative undiscounted NCF over well life ≈ $8.2M
NPV at 10% ≈ $2.4M
IRR ≈ 55%
Payout ≈ 14 months
Breakeven ≈ $42/bbl
Valid Ranges
| Parameter | Typical Range |
|---|---|
| Discount rate | 8 – 15% |
| NPV > 0 | Project is economic |
| IRR > hurdle rate (10-15%) | Investment acceptable |
| Payout | < 24 months preferred |
| PI > 1.0 | Value-creating investment |
| Breakeven (Permian) | $35 – $55/bbl |
| Breakeven (offshore) | $45 – $75/bbl |
Key Assumptions to Validate
- Oil/gas price forecast (flat vs strip pricing)
- Decline curve parameters (qi, Di, b) from type curves or analogies
- LOE and CAPEX accuracy (±20% typical for budget estimates)
- NRI and WI correctly account for royalties and overriding interests
- Tax regime (severance, ad valorem, income tax)
- Thompson, R.S. & Wright, J.D. (1985). Oil Property Evaluation. Thompson-Wright Associates.
- Mian, M.A. (2002). Project Economics and Decision Analysis, Vol. 1. PennWell.
- SPE — Economics and Evaluation Methods.
- PetroWiki — Economics: https://petrowiki.spe.org/Key_economic_parameters_for_decision_making