Decision Rule 2: No overall economic justification for a state-owned, controlled and operated oil refinery

Introduction

Last week’s column was aimed at walking readers who are unfamiliar with economic feasibility studies, through the PowerPoint presentation by Pedro Haas of Hartree Partners, on the feasibility study for a state-owned Guyana refinery. This study was conducted for the Ministry of Natural Resources (MoNR). While the previous column focused on the methods of analysis, today’s focuses on the results. Further, I utilize these results in support of Decision Rule 2, which provides guidance for decision-making as regard a state-owned local oil refinery.

The previous column had also indicated that, the prime purpose of economic feasibility studies is to give guidance on whether to proceed or not to proceed with a project. Certain standard measures are obtained to aid decision-making. These derive from the process of isolating, and then estimating, all costs (present and future) associated with the project and, similarly all benefits (present and future) expected to flow from the project. If the project is considered economically-feasible, then the benefits should exceed the costs, over the defined project period. In this formulation, all costs mean literally every cost, whether ongoing costs, operating costs, fixed costs, or variable costs. Similarly, all benefits refer literally to every benefit, including profit, performance benefits from the project, cost-avoidance benefits, as well as all other tangible and intangible benefits. Typically, these benefits and costs are estimated on the basis of several well-established economic techniques.

Previous columns have indicated that money, scheduled to be obtained in the future, is worth less than money presently held. There is in other words, a time value of money (TVM). In feasibility analysis, this is captured by the discount rate. This is the rate at which future benefits and costs, when valued in monetary terms, are discounted to their present day value. The discount rate can also be envisaged as the opportunity cost of being able to invest money elsewhere, expressed as a percentage return on investments. The refinery feasibility study sets this rate at 10 per cent per annum.

 

IRR

Based on the above observation, the first result presented in the feasibility study’s summary of its scenario results, is the Internal Rate of Return (IRR). This IRR measures the lifetime relationship between what would be invested in the refinery and the net benefits to be expected from the investment, expressed as a rate per year. In other words:

IRR =

 

 

When calculated for the oil refinery project, this rate was found to be negative.

NPV

The other measure employed in the study is Net Present Value (NPV). Like the IRR, all costs and all benefits have been calculated at present day US$, taking into account the TVM (discount rate). The NPV is therefore:

Present Value of All Benefits less Present Value of All Costs.

Only if that amount is greater than zero, is the go ahead for the project advised. As it turns out, in the Haas study the NPV has a high negative value, standing at minus US$ 3.04 billion for the base case scenario. The study refers to two other scenarios for basing this calculation, one of which obtains when the location factor for a Guyana grassroots refinery is calculated at 20 per cent and its offsite construction factor is costed at a factor of 80 per cent. Here the result is minus US$ 2.44 billion. For the other scenario, the location factor is set at 40 per cent and the grassroots effective construction factor is set at 120 per cent. In this case the negative NPV rises to minus US$ 3.69 billion.

A negative IRR reveals that the sum of post-investment cash flows is less than the initial investment. The investment in this case clearly loses money at the rate of the negative IRR. This means also that the NPV will always be negative (unless the cost of capital is negative, which is not in this case practical). A negative IRR means that the discount rate is more than the estimated oil refinery’s project discount rate or cost of capital.

Decision Rule 2

At this point I can state Decision Rule 2. Based on the Haas study, and given a worst case scenario, where this feasibility study (sponsored by the MoNR) would be rated at least 4 on a scale of 1-10 (with 10 being the best) when made available, it would be economically unjustifiable for the Guyana state to opt for putting resource gains from its oil and gas wealth into a state owned, controlled, and operated oil refinery. As I shall further argue this decision rule holds in the context of 1) the economics of oil refining, as captured in previous columns; 2) the most nationalist and sympathetic interpretation of local content policy; and 3) absence of proof that the author/sponsor of the study concocted the results, in order to deny Guyana its “birthright”, as some readers have urged on me! I shall assess these factors starting next week.

 Sensitivity analysis

Before leaving this topic I refer to the situation that, although the PowerPoint presentation does not go into details, reading between the lines the author of the study seems to have conducted a sensitivity analysis to test the robustness of his results.

What do I mean by sensitivity analysis? Sensitivity analysis is a standard technique used to assess whether the outcomes of a benefit-cost study (like the oil refinery) change significantly, if changes are made to 1) the inputs of costs/benefits;  2) the assumptions behind the study (like the estimated exchange rate); or 3) the way the analysis is set up (by using proxies for refinery margins, complexity and transportation costs to Guyana). Such sensitivity analysis is always necessary in feasibility studies because of the intrinsic uncertainty behind all assessments of future costs and benefits (since no one can know with certainty, what the future holds). Thus, the model Haas has employed and its effects remain uncertain, because the values used to estimate the unknown factors and to simulate Guyana conditions are liable to error.

Conclusion

Next week I round off this discussion with a brief revisit of the special economic factors affecting oil refining in the Guyana context and the call for local content policies. The latter usually places a local oil refinery at the leading edge of downstream diversification and industrial development.

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