Coal bed methane (CBM) is naturally formed as part of the geological process of coal creation. CBM can be recovered by drilling into the virgin coal seams, initially releasing water to lower the pressure and then allowing the methane gas to form (the methane starts in a state adsorbed on the internal surfaces of the coal). The methane can then flow, either as gas or dissolved in water to the production well. This is an important potential source of gas for the UK. However, it is controversial (often being seen as part of the fracking debate). Scotland has said that it will not support CBM. There are already CBM production sites in UK that are abandoned mines, but there have been holdups in allowing more substantial production.

In this assignment we will suppose that exploratory drilling and planning approvals have already been completed.

The estimated costs are as follows: Pipeline construction: 1.2 million Gas storage and cleaning facility: 0.6 million Other infrastructure costs: 0.6 million Production drilling: 0.3 million Total: 2.7 million

The estimated time for completion of these works is 1 year. It is estimated that coal bed methane can be profitably extracted over a period of 10 years with amounts that tend to reduce over time as shown in the following table (amounts in millions of cubic metres). Year numbers are taken from the start of production.

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 17.2 18.9 18.5 15.8 13.5 10.9 9.3 7.9 6.7 5.8

The operating costs are estimated to be 0.55 million a year (this includes maintenance, water extraction, labour etc.) Then project plan is to operate stage 1 for 5 years. After 4 years a decision point is reached when the facility may be left as it is to run through to the end of a 10-year production period in which case operating costs will remain at 0.55 million a year. Alternatively, in stage 2 additional wells and infrastructure can be built. This will cost of 1.4 million and will take a year. Thus, by year 6 the stage 2 production will be ready to come on line and will add the following amounts to the stage 1 production (amounts in millions of cubic metres)

Year 6 Year 7 Year 8 Year 9 Year 10 9.4 8.8 7.7 5.1 3.3

If stage 2 is built there will be additional operating costs of 0.3 million a year. Whether or not stage 2 is built the entire operation will be wound up at the end of ten years.

Assume that the market for gas contracts operates in such a way as to make the price of a contract match the expected price of gas over the contract horizon. The contract price now on offer for delivery over a five-year period starting in one year's time is 10 pence per meter cubed. The contract price if agreed in 5 years' time for a period of 5 years starting after 6 years (i.e. the second 5 years of production) is unknown but is estimated to have mean 10 pence per meter cubed and standard deviation of 3 pence.

(A) (70%) Using a discount rate of 4% and a real options approach evaluate the net present value of this project, highlighting any assumptions you make.

ii) Calculate the lowest price for the contract agreed in 5 year's time that will make it worthwhile to go ahead with stage 2 of the project. Carefully explain the calculations that you perform and any assumptions that you make. You will need to determine the point of the year (beginning or end) at which any payments are made, or revenues received. Make sure you state these assumptions clearly.

(B) (15%) Calculate the additional value that arises from the ability to make a decision on whether or not to go ahead with stage 2 on the basis of the gas price that is then available? This is the additional value in comparison with what would be the case if we made a decision on whether or not to go ahead with stage 2 right at the start.

(C) (15%) The analysis is sensitive to the assumptions made on the distribution of possible prices for contracts signed for the second 5-year period. Describe an approach you could take in order to estimate this distribution.