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52 comments on The Cost of Corrosion
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52 comments on The Cost of Corrosion
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ROCKMAN -
I have some familiarity with NPV analyses and am inclined to think that the fundamental weakness of this approach lies in the discount rate and how it is set. In most cases it is some arbitrary figure arrived at as an expression of what level of profitability is or is not acceptable to a company's management. You can make the NPV be almost anything you want merely by selecting a given discount rate.
Theoretically, the discount rate is determined by considering whether an equivalent return could be obtained by doing something else with the money. (Perhaps such as investing in credit default swaps and the like?) But therein lies the rub. In times like these how realistically is it to expect a 15% return on capital over a long time span?
This impinges on the question of whether there is something fundamentally flawed in our concept of the time value of money, but this is a subject that has been already covered by people such as Nate Hagens who are far more knowledgeable about the matter than I.
Since the interest rate on borrowed money is still very low, a discound rate of 10-15% would be ridiculous. Four percent is more reasonable. And when your do these analyses, you should be able to argue that the future value of the energy you are bringing in will be extremely high. (You can cite a few sources from this site, including Simmons.) That will help your bottom line.
sf -- OTOneH, you're right. OTOtherH, we can argue all we want but the companies will still use 10% or 15% DR. And as far as future price expectations don't expect much relief there. Last year when oil was bouncing around $130/bbl+ most companies were still using $70-80/bbl future prices. And many companies were actually using lower prices (by 10% or so) for Years 2 and 3 with rather modest increasing expectations for the remaining years. Turns out even at that they were a tad optimistic, weren't they? Trust me: no one but an utter idiot in the oil patch expected those prices to hold any length of time. And don't imagine there are many CEO's pounding the board room tables demanding that such optimistic price expectations as you suggest be used in the current decision making process. And that's not to argue Simmons is wrong. But future pricing optimism has always been viewed in the oil patch as the crutch of a poor manager.
We tend to leave such arm-waving theatrics to the stock brokers. Also, consider this: I deal with companies that drill in Federal waters and they are starting to discount those numbers even harder. They're anticipating, as deficets rise, the gov't will be getting greedier when it comes to revenue sharing and are thus scaling back expectations (and budgets) accordingly.
But I think you get my original point: the prevalent decision making process will be of little value dealing with our long term energy needs. The “free market” Wall Street view controls the process whether it serves the country’s long term needs or not. Really no different then how the gov’t policy of pushing sub prime home loans helped the economic short term and has now crippled us long term.
The discount rate used in a project evaluation does not have a direct connection to the fed interest rate. It's actually referred to as an IRR (internal rate of return) and has more to do with what the company regards as an acceptable number. As ROCKMAN says, it's been 15-20% for some time. Up until very recently any company could waltz out, find a hedge fund, and do that well.
Pick a lower number, and more long-term investments become possible. The problem is that everybody gotten used to gigantic ROIs and doesn't want to go back.
I agree with you joule. But to be exact, it's not so much an expectation of a 15% return on capital. A 15% return discounted at 15% = 0% return. Thus the current crunch is even worse then you describe. The 15% isn't so much arbitrary but has been accepted as the right value (more or less) for as long as I’ve been in the oil patch (33 years). It supposedly takes into account the borrowing cost of capital. Often it's also used as a ranking mechanism when there are more projects then capital.
Gail -- as far as future maintenance costs of wind turbines including decommissioning, the oil patch does handle such matters fairly well. The cost to decommission infrastructure, such as removing platforms and plugging wells, is always used in the economic analysis (future negative cash flow). And for public companies those same forward expenses are also part of the valuation. Some fudging occurs, of course, but the SEC and capital sources typically require certified estimators to generate these numbers. Your point does make me wonder how inclusive some of the cost estimates for the various alts take into account (or don't) those future deducts from cash flow.
Goes back to an old Texas saying: sometimes the cheapest part of owning a horse is what you paid initially. Such matters quickly come to mind as just last week I paid a vet another $200 for my "free” dog I rescued.
Nobody depreciates equipment over 30 year time periods, either. Most is usually front-loaded into the first few years.
yes, I think especially within US corporations the discount rate has too often been set unrealistically high which essentially devalues the future to the point where it is not really being considered after about a decade or two. I believe this has been because of their unrealistically high growth rate assumptions which in today's economy look pretty much unsustainable. By now, many people's expectations have been reset and I'll bet that future discount rates will drop.
Most companies do not use their cost of debt to determine the discount rate but instead use the "after tax weighted average cost of capital" (WACC). This takes into account what they believe is their long term optimal capital mix of debt and equity as well as the cost of each component of capitalization.
WACC = (Cost of equity capital) x (% of equity capital) + (after tax cost of debt capital) x (% of debt capital)
Publicly owned entities often use a much lower discount rate than private corporations to reflect the longer term life of their assets. There has been much debate about which discount rate to use in valuing the future costs of climage change and several economists have argued for a very low discount rate... just above 1% to take into account the impacts on future generations.
I am all for lower discount rates which are much more realistic in the way they take the distant future into account.