Simulation

SLIP is a privately held investment corporation founded in 1961. It had become a diversified company consisting of a f entirely of 9 subsidiaries. The oldest three were In the home products business a Virginia-based brass softwargon company, an outside lantern company based In Maine, and an antique re toil furniture company in Maryland. A second group of four subsidiaries formed in the sasss was focussed on research in the fields of consumer product marketing, computer software, tax research, and investment financial analysis.Hoping to capitalize on their tax and investment expertise, they belatedly build up reflect Lane Development Corporation and Spring Lane cancel Resources, which were Involved In real e conjure up development innate(p) resource exploration, respectively. Spring Lane employed a total of 525 people and had revenues of $30 million in 1987. Spring Lane Natural Resources was formed to pursue natural resource exploration because SLIP management felt that favorab le tax laws provided them opportunities to achieve significant profits In this arena.Their primary goal was to find and produce natural fellate from shale, to capture the so-called air division 29 tax credits associated with such gas. Ingress passed this tax credit In 1978 as part of the Natural Gas Policy Act in order to stimulate recitationing for natural gas found in shale. Although natural gas exploration was clearly riskier than their other investments, SLIP felt the risks could be managed by drilling only sites that were surrounded on three or four sides by existing healthfuls. To date, slur had drilled four substantiallys.It wasnt difficult operationally to drill the wells, simply It was challenging to find enough high- quality investment opportunities. In the first five months of production, unitary of the wells had already paid back 52 pctage of its initial investment well ahead of the argue payout. The other wells were also doing instead well and all were on sch edule for meeting their tar fall return on investment. smudge hopes to drill 20 more wells in 1988. Formed. This gave calumny full responsibility for choosing the sites and managing the well if gas was found. SLUR would retain near 25 percent ownership and transmit the rest to several full general partners.As managing general partner, SLUR was responsible for hiring a general contractor who would do the drilling. Slurs geologist, Brad Thomas, would determine whether there was enough gas to make it worth completing the well. If he decided to go ahead, the general contractor would be in charge of the day-to-day operations of the well. SLUR had entered into a Joint venture with Excel skill of Bridgeport, West Virginia, in which it was concord that Excel would act as the general contractor for all of Slurs wells in West Virginia. Excel also agreed to take a small ownership interest in each of these wells.The Bailey opportunity Base Case Analysis Exhibit 1 is a facsimile of the spreadsheet developed by Lisa Weatherboard to analyze the Bailey Prospect. The Bailey Prospect is surrounded by four producing wells from the target gas formation. Thus, SLUR was pretty confident that they would cause the gas formation, but they were mindful that there is always a possibility that due to geological anomalies (e. G. , drilling into a fault), a well might bolt out and result in zero production. Brad Thomas (the geologist) estimated the probability of this kind of failure at the Bailey Prospect to be about 10 percent.If they were successful, SLUR would sell the gas to pipeline distributors who would pay a price for the gas that depends on the BTU content of the gas. 2 The BTU content of the gas would not be fill outn until the well was producing, but once reducing, the BTU content would not change over the lifetime of the well. Brad Thomas estimated the BTU content of the gas to be 55 BTU per cubic foot this was the norm of the BTU contents at the nearby wells. Th e current price paid by the pipeline is $1. 90 per AMBIT (million BTU) the price paid by the pipeline would be tied to the market prices for gas and, hence, might change over time. 3 Lisa assumed that prices would grow with inflation over time. 4 The rate at which gas would flow from the well would not be known until the well was completed. Brad estimated that the gas would initially flow at a rate of 33,000 Mac thousand cubic feet) per course of instruction and then twilight following the schedule shown in Exhibit 1. The spreadsheet shown in Exhibit 1 is essentially an income statement over the life of the well. (The spreadsheet goes out 25 years only the first 13 years are shown in the exhibit. ) The gross revenue is the price per Mac of gas times the Mac of gas produced in a given year.To get to net cash flows, royalties, expenses, and taxes must be deducted 1) From gross revenue, a 12. 5 percent royalty payment to the owner of the mineral rights is deducted, leaving net reven ue. This royalty rate was the standard argental pall to ten property owners In ten west Valhalla area. 2) Excel Energy would be paid approximately $300 per month to operate the well. Lisa had budgeted an additional $3,000 per year for other expenses associated with the lease that might be incurred but couldnt now be accurately forecast. These personifys were increased annually to reflect inflation. 3) Local taxes of 4. Percent times the gross revenue would be paid to the county and a severance tax5 of 3. 4 percent would be paid to the state of West Virginia. 4) Depreciation expense for year O equaled the intangible drilling cost6, which as 72. 5 percent times the total well cost. The remainder of the drilling cost would be depreciated on a straight-line basis over seven years. 5) To compute profit after tax, depletion7, and state and federal official income taxes were subtracted from profit earlier tax. Numerically, depletion was the smaller of 50 percent times the profit forwar ds tax or 1 5 percent times the revenue. ) The state income tax equaled the tax rate multiplied by the difference between profit before tax and depletion. This tax was then reduced by a credit equal to one- half of the severance tax paid to the state. ) Federal income tax was calculated by multiplying the tax rate times the profit before tax less depletion and state tax paid. The federal tax was then reduced by an energy tax credit as allowed in Section 29 of the tax code the tax credit was determined by multiplying the current tax credit rate ($0. 76 per AMBIT in year 1) by the amount of qualifying production that year.The tax credit rate was increased each year with inflation, but its future value was in the pass of Congress and far from certain. The after-tax cash flow is given by adding back depreciation and depletion to the after-tax profit. Finally, there is the issue of the lease bonus. A lease bonus is a cash payment or bonus paid too landowner in exchange for the drilling and mineral rights. The pro represent drilling area at the Bailey Prospect lies on a farm where the owners Mr.. And Mrs.. Bryan Cotter had been reluctant to allow drilling on their land this is why the surrounding areas were developed and this property was not.Mr.. Cotter had recently passed away and Mrs.. Cotter (at the urging of her children) was now leaveing to allow drilling and production on her land. Though no offer had yet been made, SLUR had proposed pass Mrs.. Cotter a bonus of $40,000 the lease bonuses for similar properties in the area had been in this range. Financially, if the well is successful, the lease bonus comes directly off the bottom line, providing no tax deductions or depreciation. 8 on ten Dads AT tense mummers, ten prospect looked peachy It NAS an rater-tax equity payback period of about 35 months and an immanent rate of return of about 29%.To calculate the net present value (NP), Lisa discounted the cash flows using a discount rate of 15 percent, which was Slices bank vault rate for projects like this. The result was an NP of approximately $79,000. Your Assignment Your boss, Steve Bodily, had presented the results of Aliass analysis to Henry Oysters, a potential general partner. Oysters was impressed with the base-case scenario, but was very touch on about the potential downside risks. What if the well doesnt work? How do you know that it will produce that much gas? What if gas prices continue their recent decline? expert about every number in here is a guess. Bodily was prepared for the first question and knew that, if the well failed, the pretax loss would be approximately $170,000 the cost of drilling the well plus the lease bonus or a net after-tax loss of Bodily was not prepared for the other questions but promised Oysters that he would get back to him with a complete description of the risks associated with the Bailey Prospect. The goal wasnt Just to evaluate the Bailey Prospect but, more generally, to get a better unders tanding of the risks associated with the kinds of investments SLUR was pursuing.Since Lisa Weatherboard is out of town, Bodily came to you and asked you to examine the risks associated with the Bailey Prospect. Your report will go to SLIP as well as to Oysters. In your conversation with Bodily, he posed the following questions ) What are the key risks here? 2) What is the projects expected NP taking into account all of these risks? 3) How risky is this project? What is the take on that we have a shun NP on this? 4) How big lease bonus can we afford? Not that I plan to offer Mrs.. Cotter more than $40,000, but it would be good to know how far we can go and still make money. ) What if the Section 29 credit goes away? Congress has been making some encumbrance about that lately. 6) What if the well fails? While weve got the crew out there, should we drill another well? 7) Finally, I know that you dont have time to run numbers for our livelong portfolio f properties, but suppose we h ad 20 opportunities Just like the Bailey Prospect, how risky would this portfolio be? Which would the key uncertainties be? A qualitative discussion will practise we dont need hard numbers on this, but we should be prepared Tort ten question.Bodily concluded, Those are the kinds of things that come to mind. Of course, I havent had much time to suppose about it and could be missing some important issues. Ive scheduled a meeting with Oysters and some of the SLIP partners for next Thursday. Could you prepare a 20-minute presentation on this for then? Good. Thanks. Ill be out of town until then. If you have any questions about doing these kinds of analyses, you might try Jack Grayson. Hes done a lot of these risk analyses and will be at the meeting on Thursday. You might want to talk to Brad Thomas as well. Additional Information Fortunately, Brad Thomas (the geologist) was accessible and offered to help. As far as drilling another well in the event the first one fails, Thomas said, Yeah, that might be a good idea. A second well would be cheaper to drill. Of course, it would also be less likely to succeed. If the second one fails too, it would be pointless to drill a tierce ell. He estimated the cost of drilling the second well to be roughly 75% of the cost of drilling the first well you dont have to truck all the drilling equipment out again and you dont have to pay another lease bonus. The cost of completing a second well (if successful) would be the same as the cost of completing the first. Thomas estimated the probability of the second well succeeding (given that the first fails) to be . 50. He also indicated that, if the first well fails, he would rewrite his estimated initial flow rate down by a third. The decline rate would remain the same. Thomas also indicated that it would not make sense to drill a second well if the first is successful since the two wells would be draining the same area. A second well would speed production youd get roughly twice a s much production at first but you probably double the decline rate as well and end up with about the same total amount of gas (whitethornbe slightly more) and be stuck with twice the drilling cost. On the other issues Thomas said, Yeah, this business is pretty much a crap shoot. Im a geologist. I cant tell you much about Congress or natural gas prices, but I did work up some ranges on the estimates I gave Lisa. See Exhibit 2. ) Ive found that I give better estimates if I think about the ranges before I give a particular value.I actually keep track of my estimates and then later see how I did. While I dont always get the right answer, my ranges are pretty good. These ranges, Thomas says, can be interpreted as 10th and 90th percentiles numbers such that there is a I-in-10 chance that the true value will be below and above these amounts. The base case numbers used in Aliass spreadsheet can be interpreted as 50th percentiles or medians. Let me know if you need anything else. Jack Gr ayson at SLIP could only offer general advice. As far as ontogeny ranges for the other uncertainties, use your Judgment.I can send you some historical data on inflation and natural gas prices (see Exhibit 3), but looking forward well have to guess. If it is important, I may be able to get you more information next week. I know a consultant won may De addle to Nell us Walt ten gas price Toreros t. He could probably get us more on inflation too. I also know a lawyer in D. C. Who has been working with the IRS on Section 29 issues. She might be able to tell us more about that. yet I dont want to call these people unless it is important.Lets talk on Monday ND we can decide then whether to call them. Grayson also suggested that you should be careful about the discount rate. The 15 percent rate that Lisa used is risk adjusted it informally adjusts for the possibility that the well fails, uncertainty about operating costs, etc. Since you are going to explicitly model these risks, you sh ould use a lower discount rate. Because all of these risks with this investment including natural gas prices are pretty much uncorrelated with the market as a whole, I would suggest using a risk-free discount rate.The yield of 5- to 10-year treasury bonds is currently around 9 percent why onto you use that rate instead. See you on Monday. pick pick *Note The production decline judge shown near the top of the spreadsheet are highly correlated. If you have fast decline in the first year, you are likely to have rapid decline in subsequent years as well. Similarly, if you have slow decline in the first year, you are likely to have slow decline in subsequent years. To capture this dependence, we need to vary all of the decline rates together.