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Petroleum Economics Case Study: NPV vs IRR—Which Oil & Gas Project Should You Choose?



Petroleum Economics Case Study: NPV vs IRR—Which Oil & Gas Project Should You Choose?
Comparative Economic Evaluation of Project A Vs Project B
1. Learning Objective
To compare two mutually exclusive petroleum development projects using:
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Payback Period (PB)
Discounted decision criteria
And determine which project should be selected.
2. Project Description
An oil company must choose one of two development projects.
Both projects:
Begin production immediately after development
Have 5-year producing lives
Are evaluated using a 10% discount rate
Cash flows are after-tax
No inflation adjustment required (real terms basis)
The projects are mutually exclusive.
3. Cash Flow Data
Project A
| Year | Cash Flow ($ million) |
| 0 | -100
| 1 | 30
| 2 | 35
| 3 | 40
| 4 | 30
| 5 | 20
Project B
| Year | Cash Flow ($ million) |
| 0 | -150
| 1 | 50
| 2 | 55
| 3 | 45
| 4 | 35
| 5 | 25




4. Economic Evaluation
Discount rate = 10%
Step 1: Net Present Value (NPV)
Project A
Present value of inflows ≈ 119.8Initial investment = 100
NPV(A) ≈ +19.8 million
Project B
Present value of inflows ≈ 160.2Initial investment = 150
NPV(B) ≈ +10.2 million
NPV Decision
Both projects are acceptable (NPV > 0).
Since they are mutually exclusive:
Project A is preferred (higher NPV).
Step 2: Internal Rate of Return (IRR)
IRR = discount rate at which NPV = 0.
Approximate results:
IRR(A) ≈ 17–18%
IRR(B) ≈ 13–14%
IRR Decision
Both exceed 10% hurdle rate.Project A has the higher IRR.
Step 3: Profitability Index (PI)
Project A
PIA=1.20
Project B
PIB=1.07
PI Decision
Both PI > 1 → acceptable.
Project A has stronger capital efficiency.
Step 4: Payback Period (PB)
Project A
Cumulative cash flow:
Year 1 → 30Year 2 → 65Year 3 → 105
Payback occurs during Year 3.
Approximate PB(A) ≈ 2.9 years.
Project B
Year 1 → 50Year 2 → 105Year 3 → 150
Payback occurs during Year 3.
Approximate PB(B) ≈ 3.0 years.
Payback Decision
Both recover capital in similar time.Project A is slightly faster.
5. Interpretation
Although Project B generates a larger total revenue:
It requires significantly higher capital.
It produces a lower value per invested dollar.
It delivers a lower return rate.
Project A:
Generates higher NPV
Provides stronger IRR
Has better capital efficiency
Recovers investment slightly faster
6. Final Decision
Since the projects are mutually exclusive and evaluated at 10% discount rate:
Project A should be implemented.
Petroleum Economics Book: https://www.amazon.com/dp/B0H187SJM5
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