Question 2. An oil company is drilling a series of new wells on the perimeter of
ID: 2633156 • Letter: Q
Question
Question 2.
An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 20 % of the new wells will be dry holes. Even if a new well strikes oil, there is still uncertainty about the amount of oil produced: 40 % of new wells which strike oil produce only 1,000 barrels a day; 60 % produce 5,000 barrels a day.
(a) Forecast the annual cash revenues from a new perimeter well. Use a future oil price of $100 per barrel.
(b) A geologist proposes to discount the cash flows of the new wells at 30 % to offset the risk of dry holes. The oil company
Explanation / Answer
Assmptions:
1. Oil drilling happens 365 days a year
2. Total number of holes drilled (dry + oil containing) = 1000
3. Discounting needs to be applied for 1 year period
a) Total holes drilled = 1000
Dry holes = 20% * Total holes drilled = 200 holes
Holes containing Oil = 80% * Total holes drilled = 800 holes
Holes producing 1000 barrels of oil daily = 40 * Holes containing Oil = 320
Holes producing 5000 barrels of oil daily = 60 * Holes containing Oil = 480
Annual Oil Production from wells producing 1000 barrels of oil daily = 320 * 1000 * 365 = 116.8 million barrels
Annual Oil Production from wells producing 1000 barrels of oil daily = 480 * 5000 * 365 = 876 million barrels
Total Oil Production = 992.8 million barrels
Sale Price of Oil = $ 100 / barrel
Annual Cash Flow = 992.8 million * 100 = $ 99.28 billion
b) Using an annual discounting rate of 30% proposed by Geologist to account for dry holes
Net Cash Flow = $ 99.28 billion / (1.3) = $ 76,369,230,769
Difference due to discouting = $ 99.28 billion - $ 76,369,230,769 = $ 22,910,769,231
Had 200 wells which are currently dry, had not been dry then:
Holes producing 1000 barrels of oil daily = 40 * 200 = 80
Holes producing 5000 barrels of oil daily = 60 * 200 = 120
Annual production from these 200 holes would be = (80 * 1000 * 365) + (120 * 5000 * 365) = 248.2 million barrels
Cash flow from these holes would be = $ 100 * 248.2 million barrels = $ 24.82 billion
Dicounting by Cost of Capital @ 10% = $ 24.82 billion / 1.1 = $ 22,563,636,364
Discounted value at Cost to Capital ~ Difference due to discouting proposed by Geologist
Hence the rate of dicounting proposed by Geologist is seems to be a good approximation to account for dry holes
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