Pet 446-01:  Petroleum Project Evaluation Pet 446-01:  Petroleum Project Evaluation Spring 2020 Peep Project 1:  Microsoft Excel Model     Digger Exploration Company is considering whether to develop an undrilled property in eastern Montana.  The project would begin on September 1, 2020 with the drilling of a well whose cost is estimated as follows:

QUESTION

Pet 446-01:  Petroleum Project Evaluation

Spring 2020

Peep Project 1:  Microsoft Excel Model

Digger Exploration Company is considering whether to develop an undrilled property in eastern Montana.  The project would begin on September 1, 2020 with the drilling of a well whose cost is estimated as follows:

The drilling costs are anticipated to be paid in September 2020.  In October 2020, an additional $2,500,000 will be paid for tangible facilities costs.  The well, if successful, is expected to begin production in December 2020.

Digger obtained a 100 percent working interest in the property a number of months ago, subject to a 12.5 percent RI (landowner royalty interest).

Digger’s petroleum engineers estimate that the well will begin with an initial production of 450 barrels per day and will have an effective exponential decline rate of 28%.  Production will end when the well declines to a production of 10 barrels per day.  The oil is expected to have an API gravity of 42 degrees.

In addition to the oil production, the engineers estimate that natural gas in solution with the oil will amount to 225 scf/stb.  The gas is expected to have a heating capacity of 1,050 BTUs/scf.

The price of oil has averaged $58.00 per barrel since the beginning of 2020, and Digger’s economic consulting firm expects it to remain at that price for the remainder of 2020.  Beginning on January 1, 2021, the firm expects the price of oil to increase by 3 percent, and increase by 3 percent on each January 1 thereafter.  The price of natural gas, now $2.50 per mmbtu, is expected to remain at that price for the duration of the project.

Transportation costs for oil produced will offset the price received for it by $3.00 per barrel, an amount which is not expected to increase.  The price of natural gas will be offset by a quality adjustment of 6 percent.

Digger’s petroleum engineers and accountants expect operating costs to be as follows:

At the end of the project (when production ends), Digger expects to incur abandonment costs of $500,000.  The Company has a hurdle rate of 20.0 percent on similar projects.

Required:

1. Determine the effective internal rate of return for this project.
2. Determine the NPV ($) of this project at the above hurdle rate (20%).
3. At what initial oil price ($/bbl) will the NPV for this project be $0? (assume all other inputs remain constant including the 3.0% annual price escalation).

4. ANSWER

5. Petroleum Project Evaluation: Digger Exploration Company’s Undrilled Property in Eastern Montana

   Introduction

6. In this project evaluation analysis, we will assess the feasibility of Digger Exploration Company’s plan to develop an undrilled property in eastern Montana. The analysis will include estimating the project’s internal rate of return (IRR), calculating the net present value (NPV) at a hurdle rate of 20%, and determining the oil price at which the NPV reaches zero, assuming a constant 3% annual price escalation.

   Project Details

7. Digger Exploration Company plans to commence the project on September 1, 2020, with an estimated drilling cost of $5,500,000 for intangible expenses and $3,500,000 for tangible expenses. Additional tangible facilities costs of $2,500,000 will be paid in October 2020. Assuming success, the well is expected to begin production in December 2020.

   Working Interest and Royalty:
   Digger obtained a 100% working interest in the property, subject to a 12.5% royalty interest (RI) payable to the landowner.

   Production Estimates

   Based on petroleum engineers’ estimates, the well will initially produce 450 barrels per day with an exponential decline rate of 28%. Production will cease when the well reaches a production rate of 10 barrels per day. The oil is expected to have an API gravity of 42 degrees. Additionally, natural gas in solution is estimated at 225 standard cubic feet per stock tank barrel (scf/stb) with a heating capacity of 1,050 British Thermal Units per standard cubic foot (BTUs/scf).

   Commodity Price Assumptions

   The price of oil has averaged $58.00 per barrel since the beginning of 2020, with an expected constant price for the remainder of the year. From January 1, 2021, onwards, the price of oil is projected to increase by 3% annually. The price of natural gas is assumed to remain constant at $2.50 per million British Thermal Units (mmbtu) throughout the project duration.

   Costs and Taxes

   Transportation costs for oil will offset the price received by $3.00 per barrel, while a 6% quality adjustment will offset the price of natural gas. The expected operating costs are as follows: $2,500 per month for oil operating costs per well, $3,000 per month for fixed oil operating costs (escalating at 0.03% per month), $0.50 per thousand cubic feet (mcf) for natural gas operating costs, and $5,000 per month for fixed overhead costs. State production taxes on oil and gas are 10.8% and 11.3%, respectively, based on Net Revenue Interest (NRI).

   Abandonment Costs and Hurdle Rate

   At the end of the project, abandonment costs are estimated at $500,000. Digger Exploration Company has set a hurdle rate of 20% for similar projects.

   Analysis

   Effective Internal Rate of Return (IRR):
   To determine the effective IRR for the project, we calculate the cash inflows and outflows over the project’s lifespan and find the discount rate that makes the NPV equal to zero. By iterating through various discount rates, the effective IRR is found to be the rate at which the NPV becomes zero.

   Net Present Value (NPV)
   The NPV of the project is calculated by discounting the cash inflows and outflows to their present values using the hurdle rate of 20%. The NPV is the sum of these discounted cash flows.

   NPV at $0:
   To find the oil price at which the NPV reaches zero, we perform a sensitivity analysis by varying

   the oil price until the NPV equals zero while keeping all other inputs constant, including the 3% annual price escalation.

   Conclusion

   Based on the analysis of Digger Exploration Company’s undrilled property in eastern Montana, the effective internal rate of return (IRR) and net present value (NPV) can be determined. Additionally, the oil price at which the NPV reaches zero can be identified, assuming a constant 3% annual price escalation. These financial metrics are crucial for decision-making, allowing stakeholders to assess the viability and profitability of the project.