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Case 14 Northern Gushers Northern Gushers Drilling has developed a lease on the North Slope of Alaska over the last five years. They have drilled 16 production wells evenly spaced over the four square miles of the lease tract. Every well’s production declines over time, so to maintain a “steady” total flow new wells are drilled. Specifically, total production from the existing wells will decline at 17% per year if no new wells are drilled. All wells have been directionally drilled from the gravel drill pad, which also contains a processing facility (see Figure 14-1). Figure 14-1 Field Arrangement

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This processing facility separates water and natural gas from the crude oil stream. By reducing the pressure from formation to atmospheric levels, the volatile gases are removed from the oil. The oil is then dehydrated to remove water before transfer to the pipeline. As shown in the flowchart of Figure 14-2, a small portion of the natural gas is used to power the facility. Then most of the natural gas and all the water are repressurized and reinjected into the formation. This reinjection avoids the environmental problems of flaring the gas or surface disposal of contaminated water. It also helps maintain the pressure in the oil formation to increase total recovery.

Figure 14-2 Processing Flow Chart

The timing of new wells has been planned to maintain a steady flow of about 20,000 barrels of oil per day (BOPD). This flow rate is the “shipping space” on the Great Northern Pipeline that has been allotted to Northern Gushers parent company. Fluctuations in

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production are matched with the shipping space by buying, selling, and trading with other shippers at about the tariff’s cost per barrel. A second consideration has been maximizing total recovery by distributing new wells over the leased tract. Thus, each of the 16 wells has helped maintain current production and also increased total recovery from the field.

Now Northern Gusher is facing a different problem. The entire leased tract has been covered by the 16 wells. New wells will be drilled “in-between” existing wells and will therefore have less impact on total recovery from the field. Each new well will increase production now by 2000 BOPD and increase the decline rate by 1%. Since each well costs about $2 million to drill and $1.75 million to tie into the production facilities, the management of Northern Gushers must justify this decision to their parent company by identifying the rate of return on the required capital investment. Additional capital is required every 7 years to do a well work-over for $1.25 million. Abandonment costs in the final year of production amount to 10% of the initial drilling and facility costs. The abandonment costs are required by state agencies to return the land to its initial condition.

Currently, the tariff for transportation through the pipeline is $5.25 per barrel, and another $3.75 per barrel is required to ship it to market. The incremental annual operating and maintenance cost for the field is $200,000 for each new well.

At this point, Northern Gusher must decide whether to initiate planning and construction for Well 17. This particular well could come on line next year with an estimated production rate of 2000 BOPD once tied into existing separation facilities. By next year, Northern Gusher’s total production rate will fall to 18,000 BOPD. The production of the 16 wells is declining at 17% per year. With the new well added in, the higher production rate results in a field decline rate that is 1% higher at 18% per year.

For simplification, the new decline rate can be assumed to begin as soon as the new well is drilled since the field will be producing at a higher rate almost from the start. While more wells will be drilled in the future, economic analysis of Well 17 is done without considering them. Oil production at the facility will be closed down (the field will be shut-in) when the total field production reaches 500 BOPD. At that production rate, it is no longer economic to operate the field.

Because some of the oil produced by Well 17 would have been produced in later years by nearby wells, the incremental “production rate” with Well 17 versus without Well 17 will be negative in later years. This sign change in the cash flows can result in multiple rates of return, so that is an additional concern of management.

The value of oil has varied dramatically over the last six years, from a low of $18 per barrel to a high of $140 per barrel, back down to $22 per barrel and then back up to the

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current level of $45 per barrel. Because of this vast uncertainty, your boss has given you guidelines of $30 per barrel and a horizon of 20 years for the initial analysis.

Should Well 17 be added now, and how much additional oil will be produced? What is the incremental rate of return on this investment?

Options

1. If management demands an internal rate of return of 15% on investments, can Well 17 be justified now or at a later date? If now, when can well 18, 19, and so on be justified? Each of these later wells will have a similar effect on the total decline rate for the field. Specifically, assume that each well increases the decline rate by 1%.

2. Rather than considering the price of oil to be “fixed” at its current level, consider the

impact of a higher or lower inflation rate for oil than for the economy as a whole.

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Case 16 Great White Hall Flatland Views has advertised for proposals to build a new community center, but the city council cannot agree on how to evaluate the submitted proposals. The request for proposal (RFP) specified that respondents had to meet certain basic needs, although optional items could be included. The RFP also asked that each respondent calculate a benefit/cost (B/C) ratio using a discount rate of 12%. The RFP did specify the approximate size of each optional facility and the use that could be expected (and the value of such use in dollars per hour).

The RFP stipulated that the council would select a package of facilities based on estimated construction costs and B/C ratios. Since this package might not match any proposal, the council could issue a new RFP. However, if a new RFP is issued, only respondents to the first RFP may respond. The council’s intent is to provide an incentive for participation in the first RFP. Instead of a second RFP, the council could choose to simply negotiate with one of the original bidders.

Three firms responded to the RFP, but they used different assumptions on how to calculate the ratio as well as including different options within their proposals. Their construction materials and associated lives are similar, but their designs differ substantially. The proposals can be summarized as follows.

Tightfisted Proposal Averell Johnson, the conservative patriarch of the city’s construction community, has proposed a bare-bones facility (see Table 16-1). Assuming 50 years of use and end-of-period

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cash flows, his proposal has a B/C ratio of __.1 His proposal also assumes that construction expenditures are all made at the start of the construction period. Table 16-1 Tightfisted Proposal

Construction: 1 year: $2.5 million Annual operation: Gym: $120,000

City offices: $190,000 Annual benefit: Gym: 60 hours/week at $200/hour

Major Projects Proposal The proposal that has been supported by the “town and gown” crowd includes a small auditorium/theater and a library as well as the gym (see Table 16-2). Major Projects Inc. has evaluated the proposal over 30 years of use for the benefits and for a 12-month term for the construction phase. Major Projects has assumed end-of-period cash flows, but they have analyzed the construction phase as 12 months—each with an equal share of the construction expenditures. Their calculated B/C ratio is ___.1 Table 16-2 Major Projects Proposal

Construction: 12 months: $4.8 million Annual operation: Gym: $110,000

City offices: $165,000 Library: $450,000 (mostly salaries) Theater: $65,000

Annual benefit: Gym: 60 hours/week at $200/hour Library: $0.5 million in improved education Theater: 16 hours/week at $450/hour

1 The omitted B/C ratios for each facility are not necessary for the rest of the case. The “easiest” option is to calculate them.

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Energy Breakthrough Proposal The third proposal (Table 16-3) is from a new firm that specializes in the design and construction of energy-efficient structures. They based their B/C ratio, _____, on assumptions of 40 years of use and costs and benefits that flow continuously over that time (distributed rather than end-of-period cash flows). Table 16-3 Energy Breakthrough Proposal

Construction: 1 year: $3.9 million Annual operation: Gym: $ 65,000

City offices: $100,000 Theater: $15,000

Annual benefit: Gym: 60 hours/week at $200/hour Theater: 16 hours/week at $450/hour

The Council’s Solution Overwhelmed by the responses, the city council has decided to hire you as a consultant. Your contract requires you to calculate comparable ratios, to recommend a package of facilities, and to recommend a contractor.

Options

1. The problem can be simplified by specifying that all projects assume end-of-period cash flows except for construction costs, which could be specified to occur before construction begins. This may or may not be the best assumption.

2. The problem can be simplified by limiting it to the calculation of the omitted B/C

ratios. 3. The problem can be simplified by reducing the scope of the consultant’s contract to

constructing valid comparisons of the three proposals.