PrintCash flow calculations for a mining and petroleum project are similar to other businesses. The only difference is adding some tax deductions. Some of these tax deductions are mentioned in Lesson 7. More detailed information can be found at IRS Publication 535 (2019), Business Expenses under Chapter 7, Chapter 8 and Chapter 9 and also at IRS, Market Segment Specialization Program, Oil and Gas Industry (these resources are provided just for reference and for interested students). The most important items are summarized as:
Mine Development
Corporations: Expense 70%, Amortize 30% over 60 months
Individuals: Expense 100%
Mine Exploration
Corporations: Expense 70%, Amortize 30% over 60 months
Individuals: Expense 100%
Both investors are subject to a recapture provision in the event that property is deemed to be economically viable and developed.
Petroleum Intangible Drilling Costs (IDC’s)
Integrated Producers: Expense 70%, Amortize 30% over 60 months
Non-integrated producers: Expense 100%
Dry hole costs may be expensed in the year incurred by all investors
According to IRS, An integrated oil company is a producer which is also either a retailer, which sells more than $5 million of oil or gas in a year, or a refiner, which refines more than 50,000 barrels of oil on, any day during the year.
Capitalization of Costs: to charge a cost to a project and deduct over time
Depreciation related to tangible property
Personal Property (general equipment): MACRS, Straight Line, Unit of Production
Real Property (generally buildings): Straight Line
Amortization related to Intangible Property
Oil and Gas Geological and Geophysical Costs:
Non-integrated, 24 months;
Integrated, 84 months: half-year deduction in first year for all producers;
No write-off if the asset is sold or abandoned prior to the end of the prescribed amortization period.
30% Corporation Mine Development, 60 months
30% Integrated IDCs, 60 months
First year amortization deduction is generally proportional to month the asset goes into service. For qualifying oil and gas G&G, “the first year deduction is based on the mid-point of the tax year the expenses were paid or incurred.” -Tax Code Section 167(h)(1) and (h)(2). Therefore, a half-year deduction is to be considered for this class of expenditures.
Depletion: deduction unique to the resource industries
Cost Depletion of Mining
The cost of acquiring and delineating the extent and quality of a resource (including recaptured exploration) form the basis for this deduction.
Cost Depletion of Oil and Gas
Generally, the costs of acquiring an oil and gas lease (lease bonus, surveying, legal) are deducted by cost depletion. Geological and geophysical costs related to the property are deducted separately by amortization over a 24-month period for non-integrated producers, and 84 months for integrated companies.
Percentage Depletion based on an applicable percentage (table) of the net revenue (gross revenue less royalties and, in some cases, certain transportation charges).
Note that for all producers, the costs associated with product produced and sold in a tax year are generally deductible in full. These costs include labor, overhead on labor, materials, parts, and supplies for product produced and sold and most excise taxes, sales taxes, ad valorem taxes, and related expenditures.
Example 8-1: An integrated petroleum company is planning to invest in acquiring and developing an oil reserve with the following considerations:
- Total producible oil in the reserve is estimated to be 1,000,000 barrels.
- Project life is 5 years and after reserve will be depleted.
- Production rate will be 200,000 barrels of oil per year for these 5 years.
- Mineral rights acquisition cost for property would be $1,200,000 at time zero.
- Intangible drilling cost (IDC) is expected to be $6,000,000 at time zero.
- Tangible equipment cost (producing equipment, gathering lines, and well completion and so on) is \$2,500,000 at time zero.
- Working capital of $1,000,000 also at time zero.
- Equipment depreciation will be based on MACRS 7-years life depreciation starting from year 1.
- Write off the remaining equipment book value at year 5.
- The production selling price is assumed $40 per barrel which has 12% escalation each year starting from year 2.
- Operating cost is $750,00.0 annually with escalation rate of 10% starting from year 2.
- Income tax is 40%
- Royalty 15%.
- Amortization of IDC starts from time zero.
- Minimum After-tax rate of return is 24%.
| # | Year | 0 | 1 | 2 | 3 | 4 | 5 |
|
|
|||||||
| 1 | Revenue | $8,000,000 | $8,960,000 | $10,035,200 | $11,239,424 | $12,588,155 | |
| 2 | - Royalty |
-$1,200,000
|
-$1,344,000
|
-$1,505,280
|
-$1,685,914
|
-$1,888,223
|
|
|
|
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| 3 |
Net Revenue
|
$6,800,000 | $7,616,000 | $8,529,920 | $9,553,510 | $10,699,932 | |
| 4 |
- Operating cost with 10% esc.
|
-$750,000 | -$825,000 | -$907,500 | -$998,250 | -$1,098,075 | |
| 5 |
- Depreciation (Tangible producing equipment)
|
-$357,250
|
-$612,250
|
-$437,250
|
-$312,250
|
-$781,000
|
|
|
6
|
- IDC (Expense 70%)
|
-$4,200,000
|
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| 7 |
- Amortization of IDC (30% over 60 months)
|
-$360,000
|
-$360,000 | -$360,000 | -$360,000 | -$360,000 | |
| 8 |
- Working Capital Write-off
|
-$1,000,000
|
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| 9 |
- Depletion Cost
|
-$240,000
|
-$240,000 | -$240,000 | -$240,000 | -$240,000 | |
|
|
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| 10 | Taxable income | -$4,560,000 | $5,092,750 | $5,578,750 | $6,585,170 | $7,643,010 |
7,580,857
|
| 11 | - Income tax 40% |
-$1,824,000
|
$2,037,100 | $2,231,500 | $2,634,068 | $3,057,204 | $3,032,343 |
|
|
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| 12 | Net Income |
-$2,736,000
|
$3,055,650 | $3,347,250 | $3,951,102 | $4,585,806 | $4,548,514 |
| 13 | + Depreciation | $357,250 | $612,250 | $437,250 | $312,250 | $781,000 | |
| 14 |
+ Amortization
|
$360,000 | $360,000 | $360,000 | $360,000 | $360,000 | |
|
15 |
+ Working Capital Write-off |
$1,000,000 |
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| 16 |
+ Depletion Cost
|
$240,000 | $240,000 | $240,000 | $240,000 | $240,000 | |
| 17 |
- Mineral right acquisition cost
|
-$1,200,000 | |||||
| 18 |
- IDC (30%)
|
-$1,800,000
|
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| 19 |
- Tangible producing equipment cost
|
-$2,500,000
|
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| 20 |
- Working Capital
|
-$1,000,000
|
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|
|
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| 21 | ATCF | -$8,876,000 | $4,012,900 | $4,559,500 | $4,988,352 | $5,498,056 | $6,569,514 |
So the NPV at i*=24% equals $4,508,317 and after-tax ROR will be 44.8%
Here is the explanation of how to calculate each item:
Item 1: Revenue with 12% esc.
Item 2: Royalty
Is the 15% of the Revenue:
Item 3: Net Revenue
Equals Revenue minus Royalty
Item 4: Operating cost with 10% esc.
Item 5: Depreciation (Tangible producing equipment)
Depreciation will be according to MACRS 7 years Table A-1 at IRS website (this table is for 7 years, half year convention; meaning that 7 years of depreciation starts at mid first year and continues to mid 8th year). Year 1 to year 4 is similar to table and for year 5th the remaining of the book value.
Item 6: IDC (Expense 70%)
As explained above for integrated producers, 70% of IDC is eligible to be expensed.
Item 7: Amortization of IDC (30% over 60 months)
As explained above 30% of IDC can be amortize over 60 months and example 8-1 description wants it to start from time zero
Item 8: Working Capital Write-off
Non-cash deduction of Working Capital investment will be on year 5.
Note that Working Capital comes in three places in the table:
- Last year: before tax calculation with negative sign (item 8)
- Last year: after tax calculation with positive sign (item 15)
- Year 0: after tax calculation with negative sign (item 20)
Item 9: Depletion Cost
Depletion Cost, since the production in each year is constant and 1/5 of total available oil
Depletion Cost for each year = 1/5* Mineral right acquisition cost
Item 10: Taxable income
Equals the summation of all values for each year.
Note that we have -$4,560,000 tax deduction at year zero, there are two approaches here:
First, we can carry it to following years and deduct this tax deduction from taxable income in later years (loss forward).
Second, we can treat it as negative tax (which intuitively implies income). Note that the earlier we receive this money the better tax benefits we have and it will be better for the economics of the project. But you should always clearly mention which technique you are using in your analysis. Here, we assume the negative taxable income causes negative tax at year zero.
Item 11: Income tax 40%
Equals 40% of taxable income
Item 12: Net Income
Equals Taxable income minus Income tax 40%
Item 13: Depreciation
We add back the depreciation that we deducted from income to calculate the taxable income.
Item 14: Amortization
We add the amortization that we deducted from income to calculate the taxable income.
Item 15: Working Capital Write-off
We add the Working Capital Write-off that we deducted from income to calculate the taxable income.
Item 16: Depletion Cost
We add the depletion cost that we deducted from income to calculate the taxable income.
Item 17: Mineral right acquisition cost
The capital cost invested for mineral right acquisition cost is $1,200,000 and paid at time zero.
Item 18: IDC (30%)
Is the remaining of the IDC that has to be invested at time zero. Remember from above, 70% of IDC is permitted to be expensed as tax deduction.
Item 19: Tangible producing equipment cost
The capital cost invested for tangible producing equipment cost is $2,500,000 and paid at time zero.
Item 20: Working Capital
This is the capital cost that investor has to pay as Working Capital at time zero.
Item 21: ATCF
After-Tax Cash Flow: the summation of all values (between two horizontal lines) for each year.