PROBLEM 3-12 MINI-CASE CONOCOPHILLIPS GAS ACQUISITION PROJECT ConocoPhillips's (COP) Natural Gas and Gas Products Department (NG&GP) man- ages all of the company's activities relating to the gathering, purchasing, processing, and sale of natural gas and gas liquids. Chris Simpkins, a recent graduate, was recently hired as a financial analyst to support the NG&GP department. One of Chris's first assignments was to review the projections for a proposed gas purchase project that were made by one of the firm's field engineers. The cash flow projections for the ten- year project are found in Exhibit P3-12.1 and are based on the following assumptions and projections: The investment required for the project consists of two components: First, there is the cost to lay the natural gas pipeline of $1,200,000. The project is expected to have a ten-year life and is depreciated over seven years using a seven-year modified ac- celerated cost recovery system (MACRS) 20 Second, the project will require a $145,000 increase in net working capital that is assumed to be recovered at the ter mination of the project. The well is expected to produce 900,000 cubic feet (900 MCF) per day of natural gas during year 1 and then decline over the remaining nine-year period (365 operating days per year). The natural gas production is expected to decline at a rate of 20% per year after year 1. In addition to the initial expenditures for the pipeline and additional working capital, two more sets of expenses will be incurred. First, a fee consisting of 50% of the wellhead natural gas market price must be paid to the producer. In other words, if the wellhead market price is $6.00 per MCF, 50% (or $3.00 per MCF) is paid to the producer. Second, gas processing and compression costs of $0.65 per MCF will be incurred. * There is no salvage value for the equipment at the end of the natural gas lease. The natural gas price at the wellhead is currently $6.00 per MCE The cost of capital for this project is 15%. ANSWER THE FOLLOWING QUESTIONS a. What are the NPV and IRR for the proposed project, based on the forecasts made above? Should Chris recommend that the project be undertaken? Explain your an- swer. What reservations, if any, should Chris have about recommending the project to his boss? b. Perform a sensitivity analysis of the proposed project to determine the impact on NPV and IRR for each of the following scenarios: 1. Best case: a natural gas price of $8.00 and a year 1 production rate of 1.200 MCF per day that declines by 20% per year after that. o Betty Simkins Williams Companies Professor of Business and Professor of Finance, Oklahoma State University. All Rights Reserved. Reprinted with permission. Modified accelerated cost recovery system (MACRS) uses a shorter depreciable life for assets, thus giving businesses larger tax deductions and cash flows in the earlier years of the project life relative to those of straight-line depreciation. CHAPTER 3 Project Risk Analysis Exhibit P3-121 Analysis of the ConocoPhillips Gas Purchase Project 3 1 0 $ 1,200,000 145,000 0.2449 0.1749 0.1429 $ $ 6.00 6.00 720 576 $ 3.00 $ 3.00 065 0.65 Year Investment Increase in NWC MACRS depreciation rate (7 years) Natural gas wellhead price $ 6.00 (per MCP Volume (MCF/day) 365 Days per year $ Fee to producer of natural gas (per MCF) 3.00 Compression and processing costs (per MCF) 0.65 Cash Flow Calculations Natural gas wellhead price revenue $1.971.000 Lease fee expense 985.500 Compression and processing costs 213,525 Depreciation expenses 171.480 Net operating profit 600,495 Less taxes (40%) (240.198) Net operating profit after tax (NOPAT) 360,297 Plus depreciation 171.480 Return of net working capital Project free cash flow $(1,345,000) $ 531,777 $ 1.576,800 788.400 170,820 293,880 323,700 (129,480) 194.220 293.880 $1,261,400 630.720 136,656 209.880 284.184 (113,674) 170,510 209.880 $ 488.100 $ 380,390 2. Most likely case: a natural gas price of $6.00 and a year 1 production rate of 900 MCF per day that declines by 20% per year after that. 3. Worst case: a natural gas price of $3.00 and a year 1 production rate of 700 MCF per day that declines by 20% per year after that. c. Do breakeven sensitivity analysis to find each of the following: 1. Breakeven natural gas price for an NPV = 0 2. Breakeven natural gas volume in year 1 for an NPV = 0 3. Breakeven investment for an NPV = 0 d. Given the results of your risk analysis in parts b and c, would you recommend this project? Explain your answer. 5 7 8 10 0.1249 0.0893 0.0893 0.0893 0.0445 $ 6.00 $ $ 6.00 $ 6.00 461 369 6.00 $ 6.00 295 $ 6.00 236 $ 6.00 151 189 121 $ 3.00 $ 3.00 $ 3.00 $ 3.00 A 3.00 $ 3.00 $ 3.00 0.65 0.65 0.65 0.65 0.65 0.65 0.65 $330,679 165,339 $264,543 132,272 28,659 $1,009,152 504,576 109,325 149,880 245,371 (98,148) 147,223 149,880 $645,857 322,929 69,968 107,160 145.801 35.824 $807,322 403,661 87,460 107,160 209,041 (83,616) 125,425 107,160 $516,686 258,343 55,974 107,160 95,209 (38,083) 57,125 107,160 $413,349 206,674 44,779 53,400 108,495 (43,398) 65,097 53,400 129,516 (58,320) 87,480 107,160 (51,806) 77,710 103,613 (41,445) 62,168 145,000 $207,168 $ 297,103 $232,585 $194,640 $164,285 $118,497 $ 77,710 Daniel Silver AO Home Insert Draw Data Tem Project Compatibility Mode - Saved Page Layout Formulas Review View Help 10 - AA 19. Wap Text a.A. FEE Merge Center General 29 O Anal X cut Copy - Format Painter Insert Delete format Paste $ % 948-21 Conditional Format as Cell Formaning tot Styles Sort Find Filter Select- ting Coli A1 D H K ConocoPhillips Natural Gas Wellhead Project 15 Given 5 ConocoPhillips's Cost of Capital for promoct o Proce 7 10 years Solution Years 2 3 10 10 1.200.000 145,000 1429 0249 01749 0129 00090 ond 0033 0.0445 000 365 $0.00 12 Increase in WC 13 MACRS Deprae(t year) 14 Natural Gas Wetheatre per MCF) 15 Vome (MCF day 10 tys per year 17 Foto Producer of Natural Gas 18 Compression processing costs per MCF) 20 Cash Flow Calculations 21 Nolu Cas Wohad Price 22 Lease feesponse 23 Compression & processing costs 24 Deprecaton expense 25 Net operating Prote 26 Loss Tas (40) 27 Nel operating profor NOPAT) 20 Phis Depreciation expense 29 Return of networking capital 30 Project Free Cash Flow 31 32 NPV 33 IRR Project 1 template II > Arial $ % Merge & Center > Xcut I Copy Paste Format Painter Clipboard I U B NU Alignment Font A3 B A E D 26 Less: Taxes (40%) 27 Net operating profit after tax (NOPAT) 28 Plus: Depreciation expense 29 Return of net working capital 30 Project Free Cash Flow 31 32 NPV 83 IRR 34 35 2a-c. Scenario Summary Most Likely 36 Current Values Best Case Case Worst Case 37 Changing Cells 38 NG Price 39 Production Rate 900 1200 900 700 40 Result Cells 41 NPV 12 IRR 13 Notes: Current Values column represents values of changing cells at time Scenario Summary Report was 4 created 445 3. Breakeven Sensitivity Analsyis 46 Students should use Goal Seek in Excel to answer this question. 47 a. 18 Breakeven nautral gas price for an NPV = 0 49 50 b. Breakeven natural gas volume in Year 1 for an 51 NPV = 0 52 53 c. 54 Breakeven investment for an NPV = 0 55 56 Project 1 template