Economic Feasibility Study of a Chemical Enhanced Oil Recovery Project in Indonesia Based on Conventional Discounted Cash Flow (DCF) And Real Option Valuation Model: Case Study at PT ABC

: Indonesia had become an oil exporter that is recognized by the world for many years and joined The Organization of Petroleum Export Community (OPEC) – an organization that controls petroleum production, supplies, and prices in the global market – in 1962. However, oil production in Indonesia has been decreasing from year to year, one of which is due to the lack of investment in the exploration of new oil wells in Indonesia so the majority of upstream oil and gas work in Indonesia is exploiting old wells which will naturally decline steadily. This resulted in Indonesia becoming a net import oil country in 2003. Therefore, additional operations are needed to maximize oil production from these existing wells, one of which is by conducting Chemical Enhanced Oil Recovery (CEOR). The main objective of EOR itself is to mobilize the remaining oil by enhancing the oil displacement and volumetric sweep efficiency. PT. ABC, a subsidiary of PT. XYZ (a state-owned company under SKK Migas and PT Pertamina supervision) which is engaged in the upstream sector in Indonesia, is assigned by the government to carry out one of the CEOR projects that have been determined by the Government. This research covers the economic feasibility of the CEOR Project based on the conventional Discounted Cash Flow (DCF) and Real Option Valuation (ROV) Model. The revenue-sharing policy used for the project economic calculation is the gross split method. The result of the economic analysis using the DCF method is the project is not economically feasible to run as the net present value (NPV) shows negative which is -2,911 MUSD. However, the real option valuation model helped increase the value to 11,416 MUSD by adopting a strategic option which is an option to delay and time flexibility into the project. As a result, the project could be economically feasible if the operation is deferred to the following year and the oil price is over 85.2 USD/BBL.


INTRODUCTION
Indonesia is well-known of being a rich country in natural resources and cultural diversity according to world bank (2022).Besides that, Indonesia has become the world's fourth most populous nation that has around 270 million populations today.The population keeps increasing with growth is in the range 1,1% each year and it is predicted that the population would reach about 280 million in 2025.The continuous increase in population results in a continuous increase in energy needs which is believed to have an impact on Indonesia's economic growth (Herdyanti, 2021).As most of the energy consumed in Indonesia tastes from fossil energy (Herdyanti, 2021).Indonesia's oil consumption would keep increasing.İn the other hand, Indonesia's crude oil production has been steadily declining since the 1990s, owing to a lack of exploration and investment in this upstream industry.A very significant change occurred in Indonesia because domestic production cannot meet domestic demand.As a result, in 2004, Indonesia has become a net-oil importer (Hasan & Lasabuda, 2021).The increasing amount of petroleum that must be imported to meet domestic needs has caused some adverse impacts.The main one is the weakening of the rupiah exchange rate against the dollar.Therefore, the Government is trying to suppress the increase in imports to develop the Indonesian economy.The government has set a large target of oil and gas production of 1 million barrels per day of oil and 12 thousand million cubic feet per day (MMSCFD) of gas production.To realize the target in 2030, several EOR (Enhanced Oil Recovery) projects must be immediately planned and executed (Hasan & Lasabuda, 2021).Pertamina is assigned by the government to carry out the project as soon as possible.The project is located in PT.ABC's field so that PT.ABC who will be the operator of the project.However, there are obstacles that make the Company hesitate When determining a suitable discount rate, the weighted average cost of capital was considered (WACC).The WACC is calculated by adding the proportionate cost of equity and the after-tax cost of debt.Although there are other models, such as Arbitrage Pricing Theory, which is largely a multi-index model, the Capital Asset Pricing Model (CAPM) is used to assess the cost of equity, according to Elton et al (Elton, Gruber, Brown, & Goetzmann, 2003).Kodukula and Papudesu stated asserted "In the DCF model, uncertainty is handled as a risk factor.There is no potential for profit.When assessing uncertainty with the WACC formula, only downside risk is taken into account.The value may be persistently underestimated due to the bias and high level of uncertainty" (Kodukula & Papudesu, 2006).
The NPV approach's deterministic viewpoint, which builds the base value on a certain set of cash flows, As a result, the NPV model does not account for flexibility.Because it assumes a fixed or planned trajectory, the NPV model cannot account for particular decisions.Munn refers to it as "an all or nothing approach, where management cannot change the investment direction" (Munn, 2006).

Real Option Valuation Model
The RO Valuation employs a variety of approaches.This approach computes the risk-adjusted net cash flow after adjusting for each source of uncertainty.After that, the cash flow PV of Real Options was estimated using a temporal adjustment.Based on the many approaches discussed above, the RO method is the most straightforward to employ for assessing project risk characteristics.
It is critical to understand that a Real Options valuation is based on the traditional Discounted Cash Flow model and that it supplements, rather than replaces, the DCF technique for generating the DCF that underpins an asset's value.Furthermore, if management has few options for flexibility or if the investment outcome cannot be avoided, ROV will be equalized using DCF valuation as a base case.Real option valuation should thus be viewed as an extension of classical DCF valuation ( In terms of primary research, the author gathered data by conducting an interview to several experts that are working at the company.Below (Diagram 1) illustrates the stages that author take to do the study.

Diagram-1: The Research Stages
The initial step in the research process is the identification of the problem or issue.The next step is research objective that describes what the research is trying to achieve and explain why the author is pursing it.After that, the author identify the research methodology used.Research methodology is the specific procedures or techniques used to identify, select, process, and analyze information about a topic.Next, Data collection is conducted to gather information about a specific subject.In this final project, the author used quantitative data in this research.After collected the data, the author do the data processing whic is the process in translating the collected data set into valuable and usable information.The interpretation of the data that have been collected by using different analytical techniques according to the requirements of the management is called analysis.After that, the author proposed solution based on the analysis.Followed by the implementation plan which describes the tasks or actions required to implement the proposed solution in this project.Besides that, the author also set a timeframe and target dates for the completion of tasks or actions.Finally, the author would provide solutions along with the recommendation for next relevant research.Capital Budgeting Technique starts with determine the net cash flow projection every year.The net cash flow is obtained by subtracting revenue from operating expenditure dan depreciation expense, then the value is deducted by tax expense and added by depreciation expense.
After obtaining the net cash flow of the project.The cost of capital is required to determine.To know the cost of capital the project.
The author should find out the portion between equity and long-term debt obtained from the company's balance sheet.After that, the cost of equity and cost of debt must be determined.Finally, the cost of capital can be obtained by this formula After the cost of capital value is obtained, the author could calculate the discounted cash flow.Finally, the economic feasibility of the project based on the conventional capital budgeting technique can be conducted.The feasibility study is based on the Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period, and Profitability Index (PI).The basis of management considerations in deciding an investment project from the results of this NPV calculation is 1.Accept the project if NPV > 0, IRR > WACC, PI > 1 2. Reject the project if NPV < 0, IRR < WACC, PI < 1

Diagram-3: Data Processing Flow
Finding out the base case NPV is the first step of using the real option valuation model.This base case NPV refers to the NPV obtained using the conventional capital budgeting technique.After that, the uncertainties require to be identified and determine the most uncertain variable using the sensitivity analysis.In this study, the author uses spider plot to analyse the variables' sensitivity.After obtaining the most uncertain variable, the next stage is determining the managerial flexibilities or options such as option to delay, option to invest, and option to abandon with the detailed parameters.Last, the real option valuation model can be conducted and analysed.In this study, the author uses binomial lettice to calculate the real option valuation.

Monte Carlo Simulation
A monte carlo simulation is a model used to predict the probability of a variety of outcomes when the potential for random variables is present.In this study, this simulation would be adopted for understanding the probability of NPV of the project based on

RESULT AND DISCUSSION 4.1 Conventional Discounted Cash Flow
To build the cash flow projection of the project, there will be several assumptions to be used such as: PSC policy will adopt the gross split, quantity sold is 100%, production life of 13 years with drilling activities occured for 2 years, followed by the first chemical injection for 1 year.Other assumptions and the details are explained below.a.Revenue Revenue is the result of the main operational activities of this project.Revenue before split / Gross Revenue from the CEOR project itself is generated by multiplying oil production with oil prices.Oil production in this project is projected to be produced in 2026 with a production period of 13 years which is until 2038.The production projection is based on field data carried out by the field team of the project in accordance with existing historical data.Revenue after split is the final revenue for the contractor which is used subsequently to calculate cash flow.For the calculation of Revenue After Split, it is necessary to calculate the split first which is used as a multiplier to get Revenue After Split.The split is based on calculations from PERMEN ESDM No. 8/2017 and PERMEN ESDM No. 52/2017 which consists of three compositions such as base split, variable split, and progressive split.Base split of oil used is 43%, variable split would be 46%, while progressive split will have slight change every year due to the cumulative production level.e.Domestic Market Obligation (DMO) Fee.Domestic Market Obligation or DMO is the obligation of producers to sell part of their oil production to meet domestic needs.DMO on oil and gas projects is set at 25%.For this project, the production is purchased at the normal price so that the DMO Fee becomes 0.

f. Income Tax
The income tax used is the income tax that follows the provisions of Law Number 7 of 2021 concerning the Harmonization of Tax Regulations (UU HPP).Through this HPP Law, the income tax has changed to 22% starting in the 2022 tax year.

g. Net Cash Flow Projection
After doing the calculation of revenue (after gross split), operating expenditure, depreciation, tax, and interest expense then the net profit for contractor will be obtained.Depreciation will be used declining balance method based on Government Regulation no 27 year 2017.Below is the projection of the net cash flow of the project.This Interest coverage ratio shows that the estimated bond rating of the company is AAA based on Damodaran -Identify the company default spread With the bond rating found and the 15-year maturity of the project, the company default spread would be 1.01%based on PHEI.

-Risk Free Rate
For the risk free rate for this case, the author would use BI 7 days repo rate which is 7.3% -Indonesia's default spread Since, according to Damodaran, Indonesia's estimated Moody's rating Baa2, the company has a default spread of 1.62%.

-Cost of Debt
After determining the company default spread, risk-free rate, and country's default spread, the author would be able to calculate the cost of debt.Below the calculation.  =    +  +  ′      = 1.01%+ 7.3% + 2 3 × 1.62% = 9.39% -After-tax Cost of Debt To get the after-tax cost of debt, the cost of debt need to be multiplied by the tax rate which is 22%.  = 9.39% × 22% = 7.33%

Cost of Equity
Cost of Equity is the minimum rate of return that the company can theoretically provide to shareholders.The cost of equity is given as compensation for the risk that investors are willing to take to invest in the company (Gitman & Zutter, 2015).
Based on the perspective of investors, there is a return that is expected to be obtained through dividends, or an increase in the value of a given investment.The expected return, or cost of equity, is related to the financial risk inherent in the funds they invest in the company's business activities.
The CAPM method will be adobted to calculate the cost of equity.The reason for using this method is that this company as well as parent company have not gone public so the dividend discount model method cannot be applied to determine the value of its cost equity.CAPM method is also useful for helping investors see the level of risk in the project, whether or not it is following their expectations.This risk is represented by symbol β.The value of β varies, if β > 1, then the company is very volatile (risk is quite large) whereas if β > 1 then the risk is not too big and the company is less volatile than market movement.The following shows a description of the assumptions used in calculating the cost of equity using CAPM.
-Risk-free rate of return will be used the historical data from IBPA 15 years government bond which is 73% -Beta number will be used the average historical 5-year data of PT.Elnusa and Medco (same business line) which is 1,67.
-Data on market return will be based on historical data JKSE in 15 years (2007-2022) as the average of market movement.
-Risk premium is obtained by deducting the market return with the risk-free rate.  =   + [ × (  −   )   = 7,3% + [1,67 × (9% − 7,3%] = 12,75% Since R2 shows the highest cost of equity, this number would be used to calculate the WACC.The reason of using the highest cost of equity, to produce more accurate, reliable, yet secured output.

Weighted Average Cost of Capital
WACC is the weighted average of the firm's capital structure such as cost of equity and cost of debt.Cost of equity and cost of debt has been calculated by using CAPM method as mentiond above.WACC will represents the expected return on portfolio from all the firm's debt and equity.The calculation of WACC is described as below.

i.
Feasibility Analysis Based on Conventional DCF After obtaining the net cash flow of each year throughout the period from 2023 to 2041 and the weighted average cost of capital as a discount rate, the author would be able to calculate the valuation using discounted cash flow or also known as Net Present Value (NPV).The first step in the economic analysis is by determining a Discounted Cash Flow (DCF) model that will apply to the base case of the company's project development to obtain NPV, IRR, Payback Period, and Profitability Index.The summary of economic parameters of the CEOR Project for the cash flow model are shown in the table below.From table 5, it shows that the discounted cash flow resulted in a negative NPV of -1,806 MUSD which means that the project is not feasible economically as the value is below zero.Besides that, the IRR of the project is below the WACC as the standard minimum of return rate of the project.As the NPV is negative, this causes the PI doesn't meet the requirement as well.Last, the project's payback period is considered moderate which is 10 years.

Real Option Valuation Model a. Base Case NPV
Base Case NPV that is used in the real option valuation calculation is the NPV that is obtained from the DCF calculation which is -1,806 MUSD.There would be strategic options would be adopted along with the uncertainties determined in the next stage.After that, modified NPV would be shown in the ROV modelling basen on the time flexibilities and probabilities.

b. Uncertainty Identification and Modeling
To determine the uncertainty need to be involved in the real option calculation, sensitivity analysis should be conducted.Sensitivity analysis performed to show the impact of changes in uncertainty parameters assumption to overall project NPV.From the analysis result, parameter that most affects the NPV of the project could be identified.From Figure 1, it can be seen that the uncertainty that most affect the NPV project is oil price.When oil price declines by 20% the NPV would decrease significantly from -1,807 MUSD to around -35,000 MUSD and vice verca.As a consequence, oil price would the uncertain variable for calculating project valuation using real option valuation model.

c. Managerial Flexibility Incorporation
According to book, the key advantage and value of real option analysis is to integrate managerial flexibility int valuation process.Such a concept would be more attractive on an intuitive level to most managers.The alternatives that could be implemented in this project are: 1. Start the project or Invest This alternative would be applied if the NPV shows above 2 MMUSD.This alternative assumes the oil price is not wildly fluctuated which is according to the forecasted oil price.

Delay the project
This alternative would be implemented if the NPV is between -30 MMUSD and 2 MMUSD.In this alternative, the company decide to defer the project to certain time which could finally make the project's valuation increased.The maximum period to delay (t) is 5 years.

Abandon the project or Give Up
This alternative would be applied if the NPV shows below -30 MMUSD.This strategy basically is a strategy to save the investment if the oil price does not meet the target to increase the project's valuation or the decrease in oil price exceeding the cost of production and absorb all of company's resources

d. Real Option Valuation Analysis
To perform a real option valuation, researchers must first determine the initial parameters that are assumed based on the data base case scenario, history, and expert judgment.The type of option used in this project is a call option where a company wants to invest in the CEOR project which is described by number 1.The underlying asset used is the NPV when time is 0 or the base case NPV.Because the maximum period for delay is 5 years, the dividend yield used is 20%.From the projected cash flow that has been made, the resulting standard deviation or volatility is 18%.The lettice step used is 10 so that the stepping time from period 1 to the next period is 0.5.From these data, a multiplier is obtained for the uncertain variable, which is the oil price.For up step size, obtained 1.14 and for down step size is 0.88.The distribution of the NPV based on conventional discounted cash flow is illustrated by the Figure 3.As can be seen from the simulation, the project has a probability of 76% for the NPV as calculated which is -1,806 MUSD.This probability indicated that the project is predicted to have minus NPV if the project run in less than 6 months from now.The distribution of the NPV based on conventional discounted cash flow is illustrated by the Figure 4.As can be seen from the simulation, the project has a probability of around 28% for the NPV as calculated which is 12,789 MUSD.This probability indicated that the project is predicted to have quite low prediction to have that valuation if the project is delayed to next six months.However, from the simulation we can see that the project would have higher probability to have positive NPV if it is delayed.

Figure- 3 :
Figure-3: Forecast Distribution of Logarithmic NPV based on DCF

Figure- 4 :
Figure-4: Forecast Distribution of Logarithmic NPV based on ROV

Table - 1
: The Revenue Projection of The CEOR Project b. Capital ExpenditureCapital expenditure or capex is a large initial cost for a long-term project.In this project, the capex is divided into tangible and intangible capex.ISSN:

Table - 2
: The Capital Expenditure Projection of The CEOR Proeject Operating expenditure or opex in this project is divided into 3 things, namely operation and maintenance which has the largest composition, property tax, and Abandonment and Site Restoration (ASR). ISSN:

Table - 4
: The Cash Flow Projection of The CEOR Proeject ISSN:

2581-8341 Volume 06 Issue 01 January 2023 DOI: 10.47191/ijcsrr/V6-i1-29, Impact Factor: 5.995 IJCSRR @ 2023 www.ijcsrr.org 283
Cost of Debt is a funding activity obtained from long-term loans.These long-term loans can be in the form of loans through banks, shares, crowdfunding, donations, and government grants.To calculate cost of debt, the author uses syntetic rating model.The rating for a firm can be estimated using the financial characteristics of the firm.Below are the steps how to calculate the cost of debt:-Identify the interest coverage ratio by dividing EBIT by the company's interest expense.

Table - 5
: The Economic Values of The CEOR Project