Liquid Energy, an Oil & Gas company, is evaluating the purchase of one of three oil fields in Latin America. After purchasing the rights to extract oil from one of these fields, Liquid Energy will outsource the drilling activity. You have been brought in to identify the best investment for Liquid Energy.
How would you evaluate the three oil fields, and which oil field should Liquid Energy purchase?
Main steps the interviewee should take:
- Identify days it takes to drill one well in each region, using the depth and penetration rate provided.
- After this, he/she should be able to quantify the cost associated with drilling one well.
- The price and barrels extracted by day will allow the interviewee to estimate the total revenue and profit by well. It is essential to consider that in year 1 you can produce different numbers of wells in each region, and that you have limited amount of rigs.
- After achieving the calculations, the interviewee should consider other factors, risks that could affect the decision investment such as political risks, labor costs, difference in oil quality, insurance costs, future oil prices.
Short Solution (Expand) (Collapse)
The following structure would be a good approach:
First the interviewee should try to understand how to evaluate and decide which region would be the best fitting later on.
- The rights being offered to Liquid Energy give them the right to drill for 1 year, and produce oil for 20 years.
Assume that no oil is produced until the beginning of year 2.
- Liquid Energy can get the drilling operator to deploy a maximum of 10 rigs in each of the regions.
- The cost of the rig day includes crew, consumables and services.
- Any amount of oil being extracted will be sold at the spot market price of the moment.
- For simplicity assume that the oil wells will produce the same amount of oil for the next 20 years with no maintenance costs.
- The rights to extract oil cost $40 m annually in each region.
Here the interviewee should evaluate which region is most profitable.
What are the profits during the first production year?
The answer will be a function of the investment, variable costs, and quantity of oil extracted by field. This last variable will depend on the number of wells drilled in one year.
This should give the interviewee enough information to identify the number of wells and the amount of total oil that could be extracted from each field, as well as the yearly production per well.
- Spot price = $50/Barrel
Following is an overview of the calculations needed to solve the problem:
Time to complete a well
Production per well and year by region
Costs per well
Annual revenue per well
Number of wells per year
= Total revenue - Total costs
The result of these calculations should lead to the conclusions in the last step.
The interviewee should conclude and present which option would be the best one:
- Liquid Energy should invest in buying the rights for Region 2.
- It is important to recognize that even though the profit margin for Region 1 is significantly higher on a per well basis, the return of the investment depends on the total number of wells that you can drill in the first year and the upfront cost for the rights to extract oil in each region.
- Additionally, the interviewee should be able to identify other qualitative aspects of the investment that might affect the decision to invest in a certain region.
- An excellent answer would mention and briefly summarize the impact of including an expected value analysis, which would assign different probabilities of extracting the expected barrels per day
There are also other factors that could impact the decision to invest:
- Insurance costs
- Political stability of the region - Labour contracts and unions
- Volatility of oil prices
Oil quality differences
What are other issues that would need to be analyzed by Liquid Energy to fully understand the risk of the investment?
There are several “qualitative” issues that need to be considered when deciding to make an investment like this.
The interviewee is expected to mention and analyze the impact of at least two of these:
Countries have different regulations and might differ on the required insurance coverage that an Oil & Gas company will need to hold. Liability caps could vary by country, affecting the insurance cost.
Political stability of the region
Accessing a well site could become a challenge in politically unstable regions. Other property right risks could also affect the risk being bared by this firm.
Volatility of oil prices
Prices below $27/bbl will make all the regions have a negative return.
Differences in Oil quality could have an impact on the spot price.
More questions to be added by you, interviewer!
At the end of the case, you will have the opportunity to suggest challenging questions about this case (to be asked for instance if the interviewees solve the case very fast).