BREACH OF CONTRACT A term in commercial damages in Forensic Accouting- PERMIAN WATER RESOURCES INC CASE STUDY.

During the past several years, there has been significant growth in U.S. domestic oil and gas production.

Oil production in 2008 was 4.28 million barrels per day and was 10.2 million barrels per day by 2017.

Natural gas production in 2008 was 25.6million cubic feet and was 33.2miIIion cubic feet by 2017. ¹ Through the use of hydraulic fracturing and horizontal drilling, significant amounts of Oil and gas are recoverable from shale rock formations especially oil from the Bakken (North Dakota), the Permian , Barnett, and Eagle Ford (Texas) formations, and gas from the Marcellus (East) see Attachment I. Oil and gas trapped in shale formations is recovered through wells that are drilled horizontally instead of vertically as in conventional formations. Horizontal drilling drills down vertically then goes laterally along the shape of the formation and exposes more surface area for resource recovery compared to a vertical bore that passes through the formation. Once the formation is drilled, hydraulic fracturing uses pressure to crack the rock formation to permit oil and gas to be released. High quality sand is used to open and then hold open the cracks in the rocks to allow the oil and gas a pathway to flow to the surface see diagram in Attachment 2. Each "fracking" of a well can require an average of 4.2miiIIion pounds of sancP and require 3-6 million gallons of water mixed with sand and chemicals to crack the shale.³ More sand and water is required for certain formations and depending on the length of the well.

The Permian Basin in West Texas and southeastern New Mexico is an area of phenomenal production growth where production is forecast to increase from 2.6 million barrels of oil today to 4.8 million barrels per day over the next five years. The growth is a result of "producers are assembling ever larger leaseholds in the parts of the Permian they have determined to be the most promising and filling in gaps, so their holdings are contiguous and are not "checkerboarded" (interspersed with leaseholds held by other producers), That is enabling producers to drill longer horizontal wells or laterals (now often 7.500 10,000 feet, and sometimes longer). And they are intensifying their well completions with the use of more pressure, more frac sand (and more water) per linear foot of lateral and more frac stages. The water required to frac a well is increasing with the length of laterals and the intensity of well completions. A rule of thumb is that about 30% of water used to frac the well comes back to the surface as flowback water that must be disposed of. That's a lot of water but it is a one-time shot. It is the produced water (the water that was already underground, and that comes up with the oil and gas) that keeps coming and coming as daily production of hydrocarbons rises to the surface. ⁴

"According to a September 2017 study by the Bureau of Economic Geology at the Jackson School of Geology at the University of Texas (UT) at Austin, a typical horizontal well in the Permian generates about 2.7 barrels of produced water for every barrel of crude oil, and the produced water-to-crude ratio in the Delaware Basin is about 50% higher than the ratio in the Midland Basin. That 2.7:1 ratio for the Permian suggests that, with current crude production of about 2.6 million barrels a day, Permian wells are generating 7 miliion barrels of produced water [a day] that needs to be dealt with. All this water supply and produced water disposal comes at a significant cost to producers and their bottom lines."5 This results in the need for solutions to deal with large volumes of brackish and other water for disposal and/or treatment.

Water supplies are increasingly at risk in many areas, the costs of trucking, injecting and disposing of water is rising, and states are increasing their environmental and regulatory oversight in this area. The cost Of trucking water can be $10.20 per barrel - more cost-effective solutions are needed. An alternative for disposing of water by truck is on-site treatment and reuse of treated water that is estimated to cost on average $8.80 per barrelf

Permian Water Resources (PWR) is a division of a multi-segment conglomerate and the conglomerate is headquartered in Houston, Texas. PWR is headquartered in Midland, Texas and has a patented technology that extracts particulate matter from fracking waste water through a reverse osmosis filtration and water treatment process. PWR's mobile water treatment facilities can save $100,000 per well compared to trucking. PWR has significant growth opportunities if reliable equipment can be obtained.

The significant drilling activity across the U.S. and the number of projects in process has constrained water management facilities and supplies. PWR primarily uses its specialized mobile water treatment facilities and water holding tanks in serving its customers. Water treatment facility prices have increased due to industry demand and PWR is considering sourcing the equipment from outside the U.S. to get the most competitive pricing.

PWR entered into a five-year, fixed price contract in late 2015 with Trans Pacific Heavy Equipment (Trans Pacific or TPHE) to source all its mobile water treatment facilities and holding tanks during the contract period. The contract price for mobile water treatment facilities was $250,000 each and for holding tanks was $30,000 each, including shipping, any taxes or duties, and a two-year warranty on defects on alt equipment. PWR considered this an excellent price given that demand has continued to drive prices higher and PWR believed their contract prices with Trans Pacific average 10% 20% below current market prices. During the first two years of the contract, PWR purchased 60 mobile water treatment facilities and 200 water holding tanks at the beginning of each year. After two years, the PWR

⁶ Information in this section is based on Marcellus Drilling News referencing a report by Bluefield Research/Water Online (November 19, 2014) Water Management Jr Fracking Evolves.

accounting group provided analytical data indicating that the facilities purchased under the contract were suffering excessive breakdowns and repair costs that would likely continue past the warranty period. The annual repair costs for PWR are $35,000 higher for each water treatment facility compared to equipment purchased from former suppliers. Approximately one-half of the holding tanks had flaws that resulted in the development of corrosion and leaks which required $10,000 in one-time repairs for each holding tank. PWR indicated that the repair costs were responsible for significant decreases in PWR's profits and cash flows. PWR was at risk of defaulting on several contracts due to delays caused by facilities being down for repairs. PWR could also be subject to significant non-performance penalties. PWR notified Trans Pacific after two years that it was terminating the contract between the two parties. As of contract termination, PWR had reported the maintenance and repair problems to Trans Pacific but had not received any warranty payments. The following questions are needed to be answered?

A. What might PWR assert as the amount of increased costs due to repairs in the first two years of the contract of using Trans Pacific equipment?

B. What might PWR assert as the total amount of increased repair costs assuming the equipment purchased during the first two years under the contract continued to be used and has a ID-year life and PWR continued to use and repair the equipment for 8 years following termination of the contract?

C. What types of additional information would a forensic accountant need to analysis additional information of PWR's increased costs due to equipment purchased under the contract? Consider other types of costs that you would consider and impacts to PWR's business.

D.What might Trans Pacific assert as its loss if they had a gross profit margin of 20% on each equipment

E. PWR asserts that Trans Pacific was primarily responsible for PWR's decline in financial performance and potential penalties that PWR may have to pay for non-performance on their water treatment contracts. If you were the forensic accountant serving as an expert to Trans Pacific, what types of information would you request to further evaluate this assertion? Consider whether atl PWR's profit issues relate to the equipment purchased from Trans Pacific.