Question

Suppose an oil company is considering whether to develop production facilities for a newly discovered oil field on lands owned by a state government. If the firm spends $2 billion in present value in capital costs, it could install facilities capable of producing 80,000 barrels per day. Annual operating costs for the oil field are anticipated to be $30 per barrel produced. The company expects production from the field to start at 80,000 barrels per day but then decline at 9 percent annually indefinitely. The firm has to pay its investors a 10 percent annual return.

a. If the firm made the development investment, what would be the expected total oil recovery (reserves), in barrels? (Assume an infinite field life for the calculation.) Show details of your calculation.

b. If the oil price is expected to remain constant at $60 per barrel, what would be the gross revenues in the first year of production, and the present value of projected total gross revenues from the field? The firm's managers use the rate of return investors need as the discount rate. (Again, show details of your calculation).

c. The company has to pay royalties to the landowner at a rate of one-eighth (12.5%) of gross revenues. The state currently levies a production tax at a rate of 35 percent of net earnings. What are (1) expected total royalties, (2) expected total tax revenues, (3) expected developer after-tax profits, and (4) expected economic rent, all expressed as present discounted values?

d. The firm's managers are risk-averse, and decide to make their investment decisions based not on the anticipated oil price, but rather on profits that would result if the oil price were $50 per barrel. Would the company decide to make the investment?

e. The state government is facing a budget deficit due to low oil prices. The legislature is considering changing its tax regime by replacing the production tax based on 35 percent of profits with a tax based on 5 percent of the company's share of gross revenues, i.e., 5 percent of 7/8 of gross revenues. Which tax would be likely to yield more revenues? Show your calculations and explain your reasoning.

Answer 1

ANSWER: Annual Cost of Capital, I growth of production, g Capital Cost fa) Production (b) 8% 10% 1,000,000,000 14,600,000 Oil Price $45/ barrel fassumption Annual Revenue b'c NPV of annual revenue [d) (c) 657,000,000 annual revenue 1-s 3,942,000,000 Annual Operating Cost (e-b'25) 365,000,000 NPV of operating cost (f annual cost (1+i)ri-) 2,190,000,000 NPV of net operating profit before tax (g-d-f) Tax @ 35% h) Net Operating Profit after tax (I g-h] 1,752,000,000 613,200,000 1,138,800,000 NPV of Royalty @ 12.5% of Gross Revenue Assuming no tax on royalty (Fd-o.125) Total Developers after tax profit (ki 492,750,000 546,050,000 Expected economic rentfl-k-a] Note: (353,950,000) in Oil price will lead to better price NPV

At the oil price of $4S/barrel, the NPV of the project is negative which shows that the investment should not he made Also, negative economic rent shows that the competitors will stay away from the investment as there is no excess return to be earned Solution E Annual Cost of Capital, I growth, g Capital Cost (a) 8% 1096 1,000,000,000 14,600,000 Oil Price- $45/ barrel (assumption) (c) Annual Revenue (b'c NPV of annual revenue (d) 657,000,000 annual revenue (1+i)-) 3,942,000,000 Annual Operating Cost (e b 25) 365,000,000 NPV of operating cost () annual cost(1)/I-g) 2,190,000,000 NPV of net operating profit before tax 1,752,000,000 344925,000 1,407,075,000 Tax @ 10% on 7/8th of revenue@) Net Operating Profit after tax (I g-h) NPV of Royalty @ 12.5% of Gross Revenue Assuming no tax on royalty G-d 0.125) 492,750,000 Total Developers after tax profit (k =1-1) 914,325,000

(85,675,000) Expected economic rent (l-k-a) As we compare the result with solution c, it is evident that the developer's profit has increased and NPV of the project has improved as well. Hence, the tax of 10% on 7/8th of the revenue is profitable for the company