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Case Study 3: Little Judson Prospect




Question;Case Study 3: Little Judson Prospect;October 15 was another beautiful, blue-sky day;in western Albany County, Wyoming. Mick McMurry could see some cattle grazing;the fields on the high- plains dessert out in front of him. He was grateful for;the bucolic setting and his generous circumstances which were made possible by;his doing very well with some of his investments, one of which now required;some concentration. Mick was the founder and President of Nerd Gas Company. The;decision at hand was whether to drill an oil well known internally as the;Little Judson Prospect or not, in his effort to try to chaset he Niobrara shale;oil play.;The Company;Founded by Mick McMurry in 1996, Nerd Gas Company, LLC is a private;Wyoming-based energy investment company whose primary focus is on the efficient;and responsible exploration of hydrocarbons in Wyoming and the northern Rocky;Mountain region. Nerd Gas Company is one of Wyoming?s leading entrepreneurs in;energy projects in a state recognized for the depth and breadth of its;extensive mineral resources.;Nerd is currently involved in conventional oil and gas exploration;projects in the Wyoming-Utah Over- thrust Belt and the Rocky Mountain region.;Zones?of interest are primarily traditional oil or gas-bearing Cretaceous sand;reservoirs, traditional carbonate reservoirs and both structural and;stratigraphic traps. Nerd is also currently invested in other potential;energy-producing projects in Wyoming, including a ?pure play? uranium;exploration project in the Powder River Basin.;Nerd Gas Company is proud of its talented group of professionals on;staff that have spent the majority of their careers focusing on Rocky Mountain;reservoirs and solving energy production challenges. Profession- al expertise;includes land management, drilling and extraction, completions and production;and in-house energy financial analysis. The combination of strong capital, seasoned;professionals and the owner?s entre- preneurial spirit allows Nerd Gas to take;advantage of rapidly developing opportunities. In 2007, Nerd Gas Company was;awarded the Torch Award for Business Ethics by the Rocky Mountain Region Better;Business;Bureau and was the state of Wyoming?s first-ever recipient of the award.;In 2008, Nerd Gas Company contracted with the Idaho National Laboratory;(INL) to conduct a feasibility study investigating the technical and economic;viability of locating a natural gas-to-liquids (GTL) facility in the state of;Wyoming. Initial feedback delivered by INL suggested Nerd continue to advance;the project. Nerd has been working with technology providers and the state of;Wyoming in a proposed, modular-designed GTL project located in central Wyoming.;In 2011, Nerd Gas, along with three local partners possessing;significant geologic and exploration expertise, formed Stakeholder Energy, LLC.;Stakeholder was formed to pursue large-scale uranium exploration in Converse;County, Wyoming. Stakeholder has leased significant acreage ideally positioned between;a uranium processing facility and the uranium mine sites.;The list of Nerd Gas affiliated companies included: High Country;Fabrication, Jonah Bank, M&N Field Services, Nerd Technology, and;Stakeholder Energy. In 2013, McMurry-related companies employed over 225;people.;Another extension of these companies was the very generous McMurry;foundation, which has given out $49 million dollars to charitable causes in the;State of Wyoming since it started in 1998. Among the many beneficiaries of;their kindness is the University of Wyoming (UW). The foundation had given;millions of dollars each to the Wyoming Technology Business Incubator, the;Jonah field at War Memorial Stadium, the College of Business, and most recently;the new Gateway Center.;NERD?s Entry into Oil & Natural Gas;At the time of its founding, Nerd Gas Company was a successful working;interest partner in the discovery and nine-year development of both the;prolific Jo-?nah and Pinedale Anticline Fields in Sublette County, Wyoming.;These fields presented geological challenges which required new drilling and;hydraulic fracturing technology in order to successfully extract natural?gas in;these areas. Jonah Field, which was one of the largest on-shore natural gas;discoveries in the USA?in the early 1990s with 10.5 trillion cubic feet of gas;was sold to Alberta Energy (later changed its name to EnCana) in June 2000, and;the Anticline Field was sold in November 2001 to Shell Oil.;Mick had wanted the company to find some investment opportunities and;became convinced that the company could enjoy higher potential returns (30-40%;after tax) from natural resource exploration than from other investment;opportunities, including real estate, which were yielding 8-10%. Although;natural resource exploration was clearly riskier, Mick felt the risk could be;lessened by drilling only sites that were part of existing natural resource;plays, like the Bakken shale in North Dakota and the Niobrara shale in southeastern;Wyoming.;Nerd Gas (NG) had drilled four wells recently. It had not been difficult;operationally to drill the four wells, but it had been challenging to find;enough high-quality investment opportunities. Mick considered wells to be;?good? if they met all the following criteria: (1) payback of initial cash;investment in 36 months or less, (2) at least 25% internal rate of return (IRR);on an after-tax basis, and (3) a positive Net Present Value (NPV).;In the first five months of production, one of the wells had already;paid back 52% of its initial investment--well ahead of its target 36-month;payout. The other wells were also doing well, and most of them were at least on;schedule for meeting their targeted return on investment. Even though things;had gone favorably for Mick so far, he knew the pressure was still on him to;make good decisions because NG was planning to drill four more in the coming;year.;Investment Strategy;NG acted as the operating partner in the oil and gas drilling ventures;it formed, which gave it full responsibility for choosing sites and managing;the well if?oil were found. NG gathered information from the states of Wyoming;Utah and Colorado and from other companies drilling in the vicinity of a well;(if they were willing to engage in ?information trading?). Mick would then put;together a lease package for drilling 10, up to 50 wells that he considered;good investments based on all the information he had gathered. The total;initial investment for a typical package would be around $6 million up to $30;million. NG would retain about 25% ownership and sell the rest to several other;working interest partners.;As project operator, NG was responsible for hiring;a general contractor who would actually hire a firm to do the drilling;and NG?s engineer Joe Nicholas, who also had an MBA degree from UW, would;determine whether there really was enough oil to make it worth completing a;well. If the decision was to go ahead, the operator would also be in charge of;the day-to-day operations of a well. NG had entered into a joint venture with;Allen and Crouch Petroleum (A&C) of Casper, Wyoming, in which they agreed;that A&C would act as the general contractor for all the wells on which NG;acted as managing general partner.;The first-year production level varied significantly from well to well.;Joe found the uncertainty could be described with a lognormal probability;distribution with a mean of 30 barrels of oil per day (BOPD), a standard;deviation of 14 BOPD and a minimum value of zero, of course.;Drilling and Developing a Well;The most common drilling rig in operation was the rotary rig composed of;five major components-the drill string and bit, the fluid-circulating system;the hoisting system, the power plant, and the blowout-prevention system. To facilitate;the drilling process, generally a fluid known as drilling mud (composed of;water and special chemicals) was circulated around the hole being drilled. In;some cases, such as the Little Judson, air was used as the ?drilling mud.? The;major purpose of the drilling mud was to lubricate the drill bit and to carry;to the surface the cuttings that could otherwise remain in the hole and clog;it.;In the case of the Little Judson, the drilling procedure was divided;into 3 stages. The first 300 feet of hole was drilled with a 12-1/4? bit;before running 8-5/8? diameter metal pipe, referred to as casing into the;wellbore. The casing was then cemented in place, stabilizing the first section;of the hole. The second stage of the well was similar to the first, except a;7-7/8? drill bit was used to drill down to 2700 feet, before running another;casing string (production casing) into the hole. After cementing the production;casing in place NG would be ready to test the well. Because NG was worried;about the drilling fluids causing formation damage, they planned to drill into;the productive Niobrara formation using air. If the well was found to be;productive, the producing zone would be left as an ?open hole completion?;without any casing supporting the productive zone. This would allow oil to flow;through the open hole completion and up through the production casing to;the surface. The cost to drill an ?average? well in Albany County, Wyoming;location of the Little Judson Prospect, was $625,000. There was some uncertainty;however, in the cost from well to well because of such factors as differing;depths of wells and different types of terrain that had to be drilled. Experts;in the local area said that there was a 95% chance that the cost for any given;well would be within $62,500 of the average cost, assuming a normal;distribution.;The ?Little Judson? Prospect;Nerd had originally leased the rights to drill on? 32, 400 acres in;Albany County, Wyoming back in early 2009. They later split the project into;two?called the Big Judson and the Little Judson. The Big Judson (28,000 acres);was farmed out to a third party operator, with Nerd Gas just carrying a small;working interest?of 20% in the two wells that were drilled by the third party.;Upon drilling, they found hydrocarbon but the wells were considered;?uneconomic,? so nothing else was done with the Big Judson. Now, the drilling;leases are about to expire on the Little Judson. Below is a picture of the;actual potential drilling site, along with representatives from Nerd Gas and;the UW football team, that was taken for the cover of the football pro- gram;for a Fall 2013 game.;NG has the opportunity to drill and/or renew the leases for $40 per;acre. They reviewed an offsetting well in the area, drilled in the 1970s, and the;geologist noticed a high reading on the resistivity log, which normally;indicated hydrocarbons were present. He further felt that there was a high;probability of being able to use ?natural? fracturing to obtain the oil, rather;than having to use the more expensive ?hydraulic? fracturing.;Exhibit 1shows the spreadsheet;(LittleJudson.xlsx) that Joe had developed to analyze the one well, called the;Little Judson Prospect (LJP), as a potential member of the package of 10 wells;he was currently putting together for Mick and his investors (years 12-25 are;not shown). As Joe thought about the realization of this one well, he knew the;LJP had other producing wells?in the region (Niobrara Shale region). It was;therefore about a 25% chance that NG would hit the formation and decide to;complete the well, but there was a much larger, 75% chance that either they;would hit a dry hole, or have an operational failure that would cause zero;production. In either of these cases, the pretax loss would be $625K. In the optimistic;case, there would be oil produced and Joe would then find out how much the well;would produce in the first and sub- sequent years. He would also learn what;gravity the oil was, which would affect the total revenue generated by the;well.;Revenues and Expenses.The spreadsheet was;basically an income statement over the well?s life. The price per barrel was;calculated from the market value of West Texas Intermediate at Cushing;Oklahoma, which today was $104.25. The production in barrels?of oil per day (BOPD);was then estimated for the first year and calculated for each succeeding year;based on the percentage decline value given in the assumptions. The gross;revenue was just the product of the price per barrel times the barrels of oil;produced in a given year. Out of the gross revenue came a 17% royalty payment;to the owner of the mineral rights, leaving net revenue. Several expenses were;deducted from net revenue to arrive at the profit before tax:?;1.Monthly operating costs of $500 were paid to;contract operators in addition to a budgeted amount of $12,000 for other;operating expenses that might occur on an annual basis. These costs were;increased annu- ally by the inflation factor.;2.Local taxes of 6.4% times the NG gross;revenue (after royalties) were paid to the county and a severance tax of 6%;times the gross revenue (after royalties) was paid to the state of Wyoming.;3.Depreciation expense for year 0 equaled the;in- tangible drilling cost, which was 72.5% of the?total well cost. The;remainder of the initial drilling cost was depreciated on a straight-line basis;over seven years.;To compute profit after tax, the following equations applied;Profit after tax= Profit before tax -;Depletion - Federal Income Tax;Where:?Depletion = minimum of.5 * (Profit before tax);or.15 * (Net revenue)?Federal Income Tax =;Federal tax rate * (Profit before;tax - Depletion);Initial Results and Investment Considerations.;To find the net present value (NPV), Joe added back the depreciation and;depletion to the profit after tax to come up with the yearly cash flows. These;flows were then discounted at the company?s hurdle rate of 25% for projects of;this risk (see Exhibit 2for a listing of rates of return for;investments of varying maturities and degrees of risk) to calculate the NPV;through any given year of the well?s life. His pro forma analysis indicated the;project had an amazing IRR of 113% and an NPV of $1.13 million.;Joe was feeling good about the LJP, even though?he knew he had made many;assumptions. He?d used an API (American Petroleum Institute) gravity index of;40 to estimate the density of the oil because it was the expected (mean) value;when in reality he knew it could be as low as 33 or as high as 43, with the;most likely value (mode) being 41. The density of the oil affected the price;that NG could sell the oil at. An API gravity reading of 43 degrees commanded;the highest price. Below 43, the molecular chains become larger and less;valuable to the refineries. It was safe to assume that you should deduct $0.015/barrel;from the price for every 1/10 degree that the oil?s reading was below 43. For;example, oil with an API reading of 40 would cause a deduction of $0.45/barrel;in the price sold i.e., it would move the price sold from $100 down to $99.55).;He also guessed that inflation, as measured by the Gross National Product (GNP);Deflator (a measure similar to the Consumer Price Index or CPI), would average;2.5% over the 25-year project life, but he thought he ought to check a couple;of forecasts and look at the historical trends.;Exhibit 1;Little Judson ProspectBase Case;Spreadsheet;See Exhibit 3for historical oil prices and both fore- casts of;GNP Deflator values as well as historical GNP Deflator values. Joe?s idea was;to use the GNP Deflator to forecast oil prices after their four-year contract;expired.;Further Questions and Uncertainties.When?Joe showed;the results to Mick and Dick Bratton, a potential partner of Mick?s, Dick was;impressed with the ?expected? scenario but asked, ?What is the down- side on an;investment such as this?? Joe had done his homework and produced Exhibits 4 and;5 together (again years 12-25 are not shown). Exhibit 4showed the;results if there was not enough oil to develop. Exhibit 5showed what;would happen if there was enough oil, but all other uncertain quantities were;set at their 1 chance in 10 worst levels. Dick was some- what disturbed by what;he saw but said, ?Hey, Mick, we?re businessmen. We?re here to take risks;that?s how we make money. What we really want to know is the likelihood of;these sorts of outcomes.?;Joe realized he had not thought enough about the probabilities;associated with potential risks that a project of this kind involved. He also;put his mind to work thinking about whether he had considered all the things he;had seen that could change significant- ly from one project to another. The;only additional uncertainty he generated was the yearly production decline;which could vary significantly for a given well. He had used what he considered;the expected value in this case (12% per year), but now he realized he ought to;multiply it by some uncertain quantity, with a most likely value of 1.0, a low;of 0.67, and a high of 1.67, to allow for the kind of fluctuation he had seen.;Joe wondered what would be the most effective way to incorporate all six;of the uncertainties (total well cost, whether the well produced oil or not;first-year production of oil, the API gravity, rate of production decline, and;the average inflation over the next 25 years) into his investment analysis. He;remembered doing ?what if ? tables with spreadsheets back in busi- ness school;(the old College of Commerce and Indus- try or C&I), but he had never heard;of a six-way table. As he skimmed back through his decision science book, he saw;a chapter on Monte Carlo simulation and read enough to be convinced that this;method was ideally suited to his current situation.;When Joe told Mick about this new method of evaluation he was;contemplating, his boss laughed and said, ?Come on, it can?t be that hard. What;you?re talking about sounds like something they?d teach brand-new MBAs. You and;I have been doing this type of investing for years. Can?t we just figure it out;on the back of an envelope?? When Joe tried to estimate the probability of his;worst-case scenario, it came out to.001%--not very likely! There was no way he;was going to waste any more time trying to figure out the expected NPV by hand;based on all the uncertainties, regardless of how intuitive his boss thought it;should be. Consequently, Joe thought a little more about how Monte Carlo;simulation would work with this deci- sion.;In his current method of evaluating projects, he had used the three;criteria mentioned earlier (25% IRR on after-tax basis, and a positive NPV). He could see that;calculating the average IRR after several Monte Carlo trials wouldn?t be very;meaningful, especially since there was a 75% chance that you would spend $625K;on a pretax basis and get no return! It would be im- possible to find an IRR on;that particular scenario. He did feel he could calculate an average NPV after;sev- eral trials and even find out how many years it would take until the NPV;became positive. As he settled into his chair to finish reading the chapter;which looked vaguely familiar, he looked up briefly at the arid land and;wondered for a moment what resources were under that land.;Questions;1.Based on the base case scenario and the two;alternative downside possibilities, is this invest- ment economically;attractive?;2.What benefit can Monte Carlo simulation add;to Joe and Mick?s understanding of the eco- nomic benefits of the Little Judson;Prospect?;3.Incorporate uncertainties into the;spreadsheet using Crystal Ball. What do the Monte Carlo results reveal? What is;the probability that the NPV will be greater than zero? How sensitive is the;NPV to the different inputs?;4.Think about the proper discount rate?should;it be adjusted now that much of the risk has been modeled explicitly with;Crystal Ball? Should Mick invest?;Exhibit 2US Treasury and Corporate Bond Yields;Exhibit 3Historical and Forecast Data;Exhibit 3(continued);Exhibit 4Spreadsheet with No Oil Produced;Exhibit 5;Spreadsheet with Oil Found but All Other;Uncertainties Set at 1 Chance in 10 Worst Level


Paper#52481 | Written in 18-Jul-2015

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