Northern Gushers Case Study Project

Joshua Castle, Monica Farfan, Bailey Culllinan

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Table of Contents
Executive Summary ........................................................................................................... iii
Abstract ................................................................................................................................ 1
Assumptions Made ............................................................................................................ 1
Engineering Economics Justification ................................................................................... 2
Assessment of Sensitivities & Risks .................................................................................... 2
Introducing Leverage ............................................................................................................................................2
Sensitivities ...........................................................................................................................................................3
Investment Costs ..................................................................................................................................................3
Abandonment Costs..............................................................................................................................................3
Price per Barrel .....................................................................................................................................................4
Interest Rate on Loan ............................................................................................................................................4
Percent of Investment that is a Loan ....................................................................................................................4
Overall Comparison of Sensitivities ......................................................................................................................5
Decision Reversal Scenarios ..................................................................................................................................6

Conclusion and Recommendations ......................................................................................... 7

Appendix ........................................................................................................................... 8
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Executive Summary

Northern Gushers Drilling is interested in the economic impact of funding a project to drill a new
well on one of their properties. The new well will be different than the current wells in that they
would be placed between existing wells, outside the original pattern. This will cause them to
produce slightly less oil than the others. The new well is expected to increase production by 2000
barrels of oil daily, bringing their production up from 18,000 to a desired amount of 20,000. It
would also increase the decline in production that occurs naturally year by year by an additional
one percent.

The total initial investment for the project is expected be $3.75 million. This includes drilling
cost and the cost to tie the well to the rest of the facility. The project has a 20-year life span with
no salvage value. An economic analysis was performed to determine the project’s potential value
and provide recommendations on the project’s undertaking. Several estimations of unknown
values were made, and those assumptions have been stated in the body of this report.

Economic justification for the project is provided based on the values of three main economic
measures, Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period (PBP).
These values were found to be $20.9 million, 259%, and less than 2 months, respectively for the
base case. Another possibility to explore is utilizing a loan for 40% of the initial investment, at
an interest rate of 6 percent, and a 10-year period with uniform payments. The NPV, IRR, and
PBP for this case was found to be $20 million, 255%, and less than 2 months, respectively.
Therefore, based on either of these cases, it is recommended to fund the project and drill the
additional well. Additionally, it is recommended to not utilize a loan if possible since this will
slightly decrease the NPV and the IRR.

Sensitivity analyses were conducted to see the effect of the project potential if any of the
assumed values differed. Of the variables explored, which included investment costs,
abandonment costs, price per barrel, loan interest rate, and the percent of the initial investment
taken out on loan, none would change the recommendation if they were to change by 30% or
less, positive or negative. These results show the project remains viable over a range of scenarios
and provides greater confidence for the completion of a successful project. The one input
variable that is worth some consideration is the price of oil. Changes to this variable results in the
most significant effect on the profitability of the project. However, the value of a barrel of oil
would have to fall below the six year low of $18 to $13.70 for the project to no longer be
profitable.
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Abstract
The Northern Gushers drilling company has developed a lease on a property in Alaska for the
purpose of drilling over the past 5 years. Currently, the property has 16 wells spaced evenly
throughout the property. Over time the total production of oil from existing wells declines and
new wells are needed if the facility wishes to keep production at a constant rate; specifically,
20,000 barrels per day. This production rate has been set up to closely match the capacity of the
pipeline that transports the oil away from the drilling facility.

At present, the company is considering adding a well that would sit in between two existing
wells, where its addition would have some adverse effects on the facility’s oil production. It is
estimated that new wells drilled in between existing ones will increase production by 2,000
barrels per day but augment a faster decline in production by contributing an extra one percent of
decline each year. Clearly, this decision is complex, and the proper due diligence must be done
to determine if the investment is worthwhile. Several assumptions about costs are made to
determine whether to invest in the addition of the aforementioned 17th well to the property. This
report will provide the necessary information and critical analysis to address key concerns of the
business regarding the potential investment; this includes but is not limited to:
● Whether or not the well should be added now.
● The amount of oil that will be produced.
● And what the incremental rate of return on the investment is.

The purpose of this project is clear; the investment is large and the outcome uncertain, so is it
worth it? To start any project, the economics must be justified. The analysis presented in this
document aims to do exactly that. The company will be presented with what they can expect
given the current assumptions and state of the operation.

Assumptions Made
A list of all assumptions made, including the fixed values of key variables, in order to analyze
the project are listed below:
● Each new well will increase production by 2,000 barrels per day and contribute an
additional one percent to the rate of decline in oil production per year.
● Each well costs $2 million to drill and $1.75 million to tie it to the facility.
● Every seven years a well workover is needed at a cost of $1.25 million.
● Abandonment in the final year of the project amounts to a cost of 10% of the
initial drilling and facilities costs.
● The tariff for transportation through the pipeline is $5.25 per barrel.
● The cost to ship a barrel to market is $3.75 per barrel.
● The incremental annual operating and maintenance cost is $200,000 for each new
well.
● The production of the 16 wells is declining at a rate of 17% per year; the addition
of the new well would result in a decline rate of 18% per year.
● Oil production will be shut down if oil production falls below 500 barrels per day.
● The cost of a barrel of oil is valued at $30 and assumed to remain constant.
● The project is to be analyzed for a 20-year lifespan.
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● The tax rate is assumed to be 30%.

● Minimum Attractive Rate of Return has been defined as 10%.
● The base case for this project will assume no loan used, though a scenario with
leverage introduced will be explored, so the details for that are as follows:
○ Assume a loan for 40% of the initial investment of $3.75 million
○ The interest rate is six percent per year
○ The loan is to be repaid over ten years, with uniform principal payments.

Some variables with significant uncertainty are noted below:

● The value of oil has varied over the last six years from a low of $18 per barrel to a
high of $140 per barrel. Currently, the value is $45 per barrel.

Engineering Economics Justification

To justify this project and decide about moving forward, the key economic measures of return on
investment are the project's before and after-tax values of: Net Present Value (NPV), Internal
Rate of Return (IRR), and Payback Period (PBP). These values were all calculated based on the
incremental revenue value which allows us to consider the difference of adding the well versus
not adding it. Remember, the implication of adding the well is that production will be higher now
than it would be without the new well but will be lower down the road. By basing the analysis
off this difference, we can then confidently state that any level of profit is more than would be
achieved without adding the well. Therefore, a simple positive NPV would be enough to
recommend the project.

Thorough analysis has been completed with the previously stated assumptions, which can be
seen in its entirety on the spreadsheets attached in the appendix. The after-tax NPV that is
projected to be yielded by this project was found to be $20,869,762. An after-tax internal rate of
return of 259% was found with a payback period of less than one year.

The before-tax rate present value of the proposed project is projected to be $32,902,564 The
before-tax analysis yielded an internal rate of return of 376% with a payback period of less than
one year.

Assessment of Sensitivities & Risks

It was requested by the company that several “what-if” scenarios be explored. One of these
would be the introduction of a partial loan for the initial investment of the project. Other
sensitivities would be exploring a few high-impact variables at different values, and what effect
that would have on the present value. This is a common practice considering the uncertainty of
the world we live in. The purpose is to give the investor as much confidence in their decision as
possible after having explored the outcome of the scenario were it to occur under different
conditions.

Introducing Leverage
Let’s consider the possibility of taking out a partial loan for the investment; say 40% of the total
initial investment of $3.75 million. The terms of the loan repayment would be at a six percent
rate, paid over ten years in uniform payments. The loan payments are included into the
spreadsheet under the ‘Loan’ tab. The yearly payment would be $203,802.
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Taking out a loan under these conditions would set the after-tax NPV at slightly lower than the
base case, at a value of $19,993,170 which is 4% lower than the base case value. The IRR is also
slightly lower at 255%. Both cases result in a profitable and worthwhile project, but perhaps less
so with a loan. So, the recommendation would be to avoid a loan if you can, but the difference is
very minor if that would be helpful depending on the current state of the company.

Sensitivities
Five variables were considered in the sensitivity analyses. These variables are listed in the table
below.

Total Cost of Initial Investment *cost of drilling and tying well to facility

Abandonment costs *changes to the abandonment cost as a percent of

investment costs

Price per Barrel of Oil *the market value of a barrel of oil

Interest Rate on the Loan Amount *the interest rate for a loan for the initial investment

Percent of Investment that is a Loan *the percent of investment that is not a down payment
Table I. Input Variables Tested for Sensitivity

For each of the above input variables, amounts were varied and tested from a -30% to 30%
change in the assumed value and the resulting NPV was calculated for each test point. For
example, a -30% change in the value of a barrel of oil is calculated by multiplying the assumed
value of $30 with .7 to yield a test value of $21 per barrel. In the tables below the present value
of the project is recalculated for each change of the variable and listed into the “PV” column.
The value is then compared to the base case present value, where its percent change is tabulated
in the “Percent Change in PV” column.

Investment Costs
Percent Change of Variable PV Percent Change in PV
-30% $ 21,118,169.55 5.63%
-20% $ 20,743,169.55 3.75%
-10% $ 20,368,169.55 1.88%
0% $ 19,993,169.55 0.00%
10% $ 19,618,169.55 -1.88%
20% $ 19,243,169.55 -3.75%
30% $ 18,868,169.55 -5.63%
Table II. Investment Costs Sensitivity Table

Abandonment Costs
Percent Change of Variable PV Percent Change in PV
-30% $ 20,004,875.23 0.06%
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-20% $ 20,000,973.34 0.04%

-10% $ 19,997,071.44 0.02%
0% $ 19,993,169.55 0.00%
10% $ 19,989,267.65 -0.02%
20% $ 19,985,365.76 -0.04%
30% $ 19,981,463.86 -0.06%
Table III. Abandonment Costs Sensitivity Table

Price per Barrel

Percent Change of Variable PV Percent Change in PV
-30% $ 8,955,818.37 -55.21%
-20% $ 12,634,935.43 -36.80%
-10% $ 16,314,052.49 -18.40%
0% $ 19,993,169.55 0.00%
10% $ 23,672,286.61 18.40%
20% $ 27,351,403.67 36.80%
30% $ 31,030,520.73 55.21%
Table IV. Price per Barrel Sensitivity Table

Interest Rate on Loan

Percent Change of Variable PV Percent Change in PV
-30% $ 20,066,374.43 0.37%
-20% $ 20,042,320.63 0.25%
-10% $ 20,017,917.36 0.12%
0% $ 19,993,169.55 0.00%
10% $ 19,968,082.24 -0.13%
20% $ 19,942,660.59 -0.25%
30% $ 19,916,909.84 -0.38%
Table V. Interest Rate on Loan Sensitivity Table

Percent of Investment that is a Loan

Percent Change of Variable PV Percent Change in PV
-30% $ 20,256,147.23 1.32%
-20% $ 20,168,488.00 0.88%
-10% $ 20,080,828.78 0.44%
0% $ 19,993,169.55 0.00%
10% $ 19,905,510.32 -0.44%
20% $ 19,817,851.09 -0.88%
30% $ 19,730,191.86 -1.32%
Table VI. Percent of Investment that is a Loan Sensitivity Table

If there was to be one main impression left by these tables, it should be that of the variables
tested only the ‘Price per Barrel’ was sensitive enough to change the overall present value of the
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project by more than six percent. Other variables demonstrated an ability to influence the project
to a degree, but their effect due to change would be belittled by a much smaller change in the
value of a barrel of oil.

Overall Comparison of Sensitivities

The values in the tables can be compared and viewed more easily in the sensitivity plots in
Figures 1 and 2. Each variable is represented by a line which has a slope value that represents the
present value of the project divided by the amount of percentage change from the assumed value
for the variable. A steeper slope signifies a more sensitive input variable. By comparing these
slopes for each input variable, it is apparent the value of a barrel of oil is far more sensitive than
any other variables tested.

Sensitivity Analysis Plot

$35,000,000.00

$30,000,000.00

$25,000,000.00
Present Value

$20,000,000.00

$15,000,000.00

$10,000,000.00

$5,000,000.00

$-
-40% -30% -20% -10% 0% 10% 20% 30% 40%
Percent Change of the Input Variable

Investment Costs Abandonement Costs Price per Barrel

Interest Rate on Loan Percent of Investment as a Loan

Figure 1. Sensitivity Analysis Plot

For clarity in comparing the sensitivity of other variables other than the “Price per Barrel”
variable, it was removed from the plot and rescaled in figure 2 below.
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Sensitivity Analysis Plot (excluding cost per barrel)

$21,500,000.00
$21,000,000.00
Present Value

$20,500,000.00
$20,000,000.00
$19,500,000.00
$19,000,000.00
$18,500,000.00
-40% -30% -20% -10% 0% 10% 20% 30% 40%
Percent Change of the Input Variable

Investment Costs Abandonement Costs Interest Rate on Loan Percent of Investment as a Loan

Figure 2. Sensitivity Analysis Plot (excluding cost per barrel)

Decision Reversal Scenarios

As part of our sensitivity analysis, a what-if scenario was performed to test the amount of change
necessary to reduce the present value to zero and thus reverse the recommendation of completing
the project. These values for the decision reversal point are summarized below.

Input Variable Estimated Value Decision Reversal Point

Investment Cost $3,750,000 $ 23,743,169.55

Abandonment Cost 10% 5134%

Price per Barrel $30 $ 13.70

Interest Rate on Loan 6% 323%

Percent of Investment that is a Loan 40% 952%

Table VII. Table of Decision Reversal Scenarios

As the table shows, a rather significant change to any one of these estimated values would have
to occur for a reversal in the project recommendation. Of the variables tested only one is
sensitive enough to be noted, the value of a barrel of oil. If the price per barrel drops below
$13.70 the project is no longer recommended. For what it’s worth, it seems unlikely that the
price would drop this low as the six-year low point for the price of oil was $18.
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Conclusion and Recommendations

The most important consideration regarding this project was if the additional production of oil
gained now would be worth it to counter the longer-term negative decline in production of the
entire oil field. The new well would produce 2,000 more barrels per day but, due to its intrusive
location between two other wells, would increase the rate of decline for overall production an
extra percent each year. What we have determined through analysis up to this point, with the
given assumptions, is that the gains do counter the future loss, and the project is worthwhile to
carry out. Specifically, we have found the Net Present Worth is upwards of $20 million for our
base case. We considered the case of taking out a loan for part of the initial investment, which
was closely profitable but slightly less, so should be avoided if possible. By conducting
sensitivity analyses for five different critical variables, we would the project easily withstands
30% changes to each. The project is recommended on the basis of its profitability and minimal
sensitivity to unexpected changes.
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Appendix