The Mackenzie Oil Co. owns a small field named Lobster, currently producing 11,800 barrels of oil per day. The Operator is considering whether to work-over the producing wells in order to improve the performance of the field. The major impact of the work would be to improve productivity in the short term, but at the expense of production in the longer term. Some improvement in overall recovery is also expected.

The work-overs would cost $15 million and could be completed during 2020. As a result of the accelerated production, the field life is expected to be reduced by one year. You are required to advise the management whether to proceed with the planned investment. The current planned and accelerated production profiles and other required information are presented in tables below. These costs are in $2020 terms.

Year

Current Profile

(bopd)

Accelerated Profile

(bopd)

2020

11800

11800

2021

10000

10400

2022

8510

9310

2023

7220

8220

2024

6150

7150

2025

5200

5800

2026

4440

4640

2027

3760

3560

2028

3200

2900

2029

2740

2340

2030

2340

1840

2031

2000

0

Assumptions

Oil Price:

$50.00

Oil Price Escalation Rate:

1.50%

Royalty Rate:

25%

Oil Production Cost per Barrel:

$10.00

Operating Cost Escalation Rate:

1.00%

Income Tax Rate:

30%

Part 2:

The Mackenzie Oil Co. has recently completed its evaluation of a new structure (Juniper) and is satisfied that reserves of oil are sufficient to justify the installation of production facility costing $150 million. Furthermore, management is keen to proceed immediately in order to absorb available cash flow from the company's Aspen Field, which has recently achieved peak production.

A further, adjacent structure, named the Rowan prospect, was discovered last year and has been the target for further seismic investigation. The Exploration Department is optimistic that commercial reserves will be demonstrated in the near future. Management accepts the current assessment that the probability of commercial reserves being identified in the Rowan structure is 35%;

If this oil does exist, the production facility currently planned for Juniper would be inadequate for both reservoirs and, consequently, an expansion in production facility would be required. Alternatively, Mackenzie Oil could decide now to install a larger facility, with capacity for both reservoirs. This option is estimated to cost $225 million.

The drilling rig, Arbor 1, has been leased to drill a single appraisal well on Rowan this year and these results will certainly provide a better indication of the economic potential of the structure. The reliability of this appraisal well is predicted by the company to be around 0.6, meaning that whatever the prognosis, there is a 60% probability that it is correct. If the development decision is delayed until this appraisal result is available, the Juniper program would slip by a year and the company would face a larger short-term tax liability, equivalent to an additional current payment of $35 million. One further well is planned for the Rowan structure next year, but management is not prepared to delay the Juniper decision beyond the result of the first appraisal well.

The Mackenzie Oil management has decided to proceed with the Juniper Field development no later than the completion of the well currently being drilled by Arbor 1. There is, however a problem of deciding whether to proceed with a smaller capacity or to install a larger production facility.

1.Advise the management of Mackenzie Oil as to the optimum strategy in order to minimize the expected cost of the Juniper / Rowan Field development. Note that this requires the construction of a decision tree incorporating the logic of the problem, relevant cost information and probabilities. No revenue information is presented or required.

2.There is some disagreement within the company regarding the probability that Rowan is commercial and management would like advice on the sensitivity of its decision to variation in estimates of the commerciality of the Rowan structure. Investigate the impact of changing this assumption in order to establish the range of values for which the determined optimum strategy remains optimum.

3.A second drilling rig, Arbor 2, may be available now at a very high spot rate. The opportunity therefore exists to bring forward the well planned for next year and to have the information available in time to contribute to the Juniper decision. If the two appraisal wells together on Rowan were considered to provide a reliable assessment, how much extra should Mackenzie Oil be prepared to spend to have this well drilled now rather than next year?

Note that "reliable" in this context means that no matter what the result of the appraisal well, the interpretation provides an accurate assessment of the economic viability of the structure.