The Prices of Oil and Gas
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[pic 1][pic 2][pic 3][pic 4]Executive SummaryThe prices of oil and gas had fallen dramatically during the 1980s and recovered only a little by the end of the decade, which depressed the profitability of companies in the oil and gas exploration and production industry. Amoco, North America’s largest private holder of natural gas reserves, decided to respond to the low energy prices by divesting marginal properties that could be more efficiently operated by low-overhead independent companies. As a result, MW Petroleum (MW) was established as a free-standing subsidiary.Apache, an independent company with efficient operations of small- to medium-sized properties, developed a strategy that involved growing and enhancing the company’s standing among U.S. independents through the acquisition of producing properties. MW was an ideal acquisition target for Apache as it was comprised of properties well-suited to Apache’s operating capabilities and would add stability in Apache’s revenue stream as MW’s reserves diversify Apache geographically and its production structure would mitigate the extreme volatility of gas price (Exhibit 1).Case ProblemTo successfully structure a proposal that would be profitable for Apache and satisfy Amoco’s desire to sell MW at a good price, Apache had to come up with a comprehensive and careful valuation of targeted properties, including both developed and undeveloped reserves. However, the volatility in oil and gas prices and uncertainties about the profitability of MW fields made it difficult to precisely project the value of targeted properties.In addition to valuing MW’s reserves, Apache also had to make decisions about when to invest in those undeveloped reserves to maximize its profits, as well as how to attract lenders to adequately finance this transaction externally. Detailed Analysis We started with valuing the aggregated reserves using APV without considering Apache’s option to defer the investment in undeveloped reserves. We used 13% as our cost of asset, which was the rate used in calculating the terminal value, to discount the cash flows of aggregated reserves, resulting in unlevered present value of $473.5MM (Exhibit 2). We made several assumptions to arrive at the present value of interest tax shield. First, we assumed the cost of debt equaled the yield of BB bonds, which is 12.3%. Second, the tax rate was constant at 35%, which was the average tax rate over 15 years based on the aggregated cash flow projections. Third, we assumed that Apache was able to leverage its debt capacity, which was 50% of the value of proved reserves. Fourth, all MW reserves would become proved immediately since Apache wouldn’t defer its investments in undeveloped reserves. That being so, we calculated the interest payment in each year by multiplying 50% of the value of proved reserves by 12.3%. The present value of the interest tax shield, discounted at the cost of assets, was $63MM, leading to the value of aggregated reserves of $536.5MM (Exhibit 3).
Next, we valued MW reserves by separating developed and undeveloped reserves because the rights to defer development expenditures for 5-7 years provided Apache “real options” to decide whether to invest or abandon the undeveloped reserves, based on changing economic and market conditions. The APV approach failed to account for potential benefits provided by real options. Consequently, the results from the all-APV approach are deemed to be lower than valuing MW as a portfolio of assets-in-place and options. We started our portfolio valuations using the APV approach to calculate the present value of developed reserves, equal to $383.84MM (Exhibit 4), and the interest tax shield, equal to $35.6MM, under the same assumptions we made for the all-APV method (Exhibit 5). Then we analyzed the value of the options on proved undeveloped reserves, probable reserves, and possible reserves using the binomial option pricing model. In determining the annualized standard deviation of each option, we assumed standard deviations of oil and gas prices would remain constant at 50% and 35%, respectively. We allocated weights to the two underlying assets based on the present value of expected revenues, as revenue represented production multiplied by price (Exhibit 6). We then computed the standard deviation of each option based on the weights, volatility and correlation of oil prices and gas prices. Accordingly, we used 45% as the σ for proved undeveloped reserves, 43% for probable reserves, and 47% for possible reserves (Exhibit 7). When computing other key inputs in the option pricing, we decided that the spot price referred to the present value of nondiscretionary cash flows discounted at the cost of assets, which reflected normal risk of projects, while the strike price referred to the present value of discretionary cash flows discounted at the risk-free rate, which we assumed to be the 10-year treasury bond yield of 8.03% to match the life of the project (Exhibit 8). We also presumed the maturity of each option was 6 years. With previously stated assumptions, we determined that the value of the proved undeveloped reserves was $52.9MM; the value of the probable reserves was $52.7MM; and the value of the possible reserves was $43MM (Exhibit 9). Therefore, the value of MW’s portfolio comprised of assets-in-place and options added up to a total of $593MM, including the unlevered present value of proved developed reserves, present value of interest tax shield, value of real options on proved undeveloped reserves, probable reserves and possible reserves, as well as other opportunities valued at $25MM (Exhibit 10).