# Eco05

## Economics Exam Help 05

Section 1 – Technical questions

Question 1 – Cash flows

Peak Oil Services plc (POS) is the sole owner of J Block, located in the Central Basin of the North Sea. This is a complex multi-layered structure, with original reserves of 110 million barrels of oil, on which production started in 2004.

The historic and estimated future oil production, associated costs, and the economic parameters are as follows (all monetary figures are given in constant £2015):

Opex consists of two components, a fixed and a variable component:
The fixed component is £20155 m per annum.

 The variable component is £2015 2 per barrel, including export costs.
Corporation tax rate is 62%, payable fully in the year it is due. There is no other form of tax and the field is taxed on a consolidated basis. Capital allowances are 100% allowable in the year in which they arise.

For evaluation purposes, the oil price is assumed to be £201535 per barrel. Inflation is constant at 2% throughout the life of the project.

(i) POS were offered £2015150m for J Block in late June 2012. Assuming the appropriate discount rate for the J Block project to be 10%, calculate the NPV[0.10] of the project at that date and discuss whether POS were correct to decline this offer.(15 %)

(ii) Assume it is now mid-2015. POS are currently considering a workover to reduce water production, which would also permit incremental oil recovery (extra to the original production estimates) as given in the table below. Based on this table and the further information below (all monetary figures are given in constant £2015), would you advise POS to proceed with the workover?

•  The capex for the workover is expected to be £2015 25 m in 2015.

•  The abandonment capex is estimated to rise by £2015 10 m.

•  The abandonment date will be delayed by one year to 2020.

•  The increase in fixed opex brought about by the workover is estimated to be £2015 1 m per year.

•  The appropriate real discount rate for the workover is 15%.

Question 3 – Tree diagram

Fisher Oil Ltd is an oil exploration company with a preliminary drilling license in a certain small acreage. The company currently faces the following three possibilities:

a. carry out the drilling itself,

b. farm-out the drilling, or

c. sell the licence to another operator (assuming this is possible).

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If Fisher Oil carries out the drilling it will incur \$3 million for drilling the first well, which based on current information maybe a dry hole with probability 45%, a marginal producer with probability 35%, or a good producer with probability 20%. In that acreage a marginal producer is estimated to bring in \$5 million in revenue, and a good producer \$8 million in revenue.

If the first testing well turns out to be a dry hole, then the company may choose to abandon or, alternatively, acquire 2D seismic information for part of the acreage and drill a second well accordingly at a total cost of \$4.5 million. Although the 2D seismic information is assumed perfect in revealing a structure if it is present, due to possible migration this structure is likely to be a good producer with probability 60%, a marginal producer with probability 30% or a dry hole with probability 10%. However, in this seismic assisted case, and only in this case, better recovery management means that a marginal producer will most likely bring in \$7 million in revenue, and a good producer \$10 million.

Fisher Oil may instead farm out the licence acreage to a more specialised company whereby it receives 30% of revenue if the farming effort yields a good producer, 25% of revenue if it is a marginal producer and 0% if it is a dry hole. The drilling experience of the farmed to specialised company together with the particular knowledge it has in the blocks around the acreage may yield a good producer with a probability of 55%, a marginal producer with a probability of 25% and a dry hole with a probability of 20%. Seismic investigation is not available to the farmed to company.

The third option open to Fisher Oil is to sell the licence now to another operator for \$1.8 million. This option will not be available at a later date.
Assume that all expected revenue figures are expressed as a present value. Answer the following questions.

(i) Draw a tree diagram that represents the logic and outcomes of this problem and use it to advise Fisher Oil on the optimal option to follow.(15 %)

(ii) Compare and contrast the possible risks involved in the three options available to Fisher Oil and discuss how the advice you gave earlier to Fisher Oil in your answer to part(i) should, or should not, be revised or augmented in light of your answer to this question.

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