Making Oil And Gas UpstreamMidstream Investment Decisions

1
Making Oil And Gas Upstream/Midstream Investment
Decisions
Presentation To Senate Resources
Committee Legislative Budget Audit
Committee Hearings Alaska Natural Gas Pipeline
Issues

• Presentation By
• Ken Thompson, President CEO
• Pacific Star Energy LLC

2
Agenda

• Importance of capital budgeting and allocation in
  a corporation to decide what projects to approve
• Framework of the capital budgeting process
• Capital projects portfolio
• Investment criteria
• Sensitivity
• Risks and risk mitigation
• Commercial vs. competitive rates-of-return
• Conclusions

3
My Experience With Capital Portfolio Budgeting
Decisions

• Currently a Director on Board of Directors,
  Alaska Air Group, and has helped set and approved
  capital portfolio guidelines
• Currently a Director on BOD, Coeur dAlene Mines
  Corporation and has helped set and approved
  capital portfolio guidelines
• Was an Executive VP of ARCO in L.A. (1998-2000)
  and sat in on ARCO BOD meetings helped set and
  solicited approval of capital portfolio
  guidelines and mix of projects in the portfolio
• Past President of ARCO Alaska, Inc. (1994-98) and
  argued the case for Alaska project requests to be
  included in ARCOs approved capital portfolio
• Past Manager of ARCO Corporate Planning to review
  and solicit approval for upstream, midstream and
  downstream investments

4
The Importance Of Capital Budgeting And
Allocation

• One of the most significant financial activities
  of a firm
• Determines the core activities of the firm over
  a long term future
• Confirms which projects receive capital to
  proceed timely and which projects do not receive
  capital
• Not all projects that are commercial or even
  competitive are approved internally when capital
  is constrained
• Capital constraints force an allocation process
  that selects a project mix that maximizes
  shareholder wealth
• Decisions must be made carefully and rationally
  with owners, i.e. shareholders, in mind

5
How Capital Budgeting Fits Into The Financial
Planning Of A Corporation
6
Broad Framework For Capital Budgeting

• Identify company strategy overall and how the
  strategy works to maximize shareholder wealth
• Establish system for evaluating projects,
  preparing capital allocation requests consistent
  with strategy
• Idea phase
• Preliminary evaluation phase
• Business evaluation phase
• Go-ahead or reject phase
• To be approved, a project must pass all these
  phases
• Develop a culture consistent with the strategy
  and the capital evaluation system

7
Capital Projects Portfolio

• Safety or environmental project outlays required
  by law or company policy
• Maintenance or cost reduction projects
• Expansion in existing businesses Major Oil
  Co. Capital
• Upstream Exploration (10 of
  capital)
• Upstream Development and production
  (50-60 of capital)
• Midstream Pipelines, natural gas processing
  (10 of capital)
• Downstream Oil refining and retail marketing
  (20 of capital)
• Chemical manufacturing
  (10 of capital)
• Investment for new products or ventures
• Discretionary or non-discretionary

8
Decision Criteria For A Capital Project To Even
Be Considered For The Portfolio

• Internal rate-of-return (IRR)
• Commercial, i.e. exceed cost of capital plus
  premium (e.g. 12)
• Competitive, i.e. create the best mix of future
  cash flows when multiple projects can be selected
  from (e.g., 15)
• Discounted cash flow net present value (NPV)
• Payback period
• Profitability index
• Sensitivity analysis
• Risk assessment
• Discretionary or non-discretionary

9
Decision Criteria Definitions

• Net present value (NPV) indicates the expected
  impact of the project on the value of the firm.
  The NPV is the present value of all expected cash
  flows including the investment dollars both
  positive and negative cash flows are considered.
  A discount rate is chosen to get discounted net
  present value. The NPV decision rule specifies
  that all independent projects with a positive NPV
  should be accepted. When choosing among mutually
  exclusive projects and when capital is
  constrained, the projects with the largest
  positive NPV combination should be selected.
• Internal rate-of-return (IRR) is the discount
  rate at which the net present value (NPV) of a
  project equals zero. The IRR decision rule
  specifies that all independent projects with an
  IRR greater than the cost of capital should be
  accepted when there are no capital constraints.
  When choosing mutually exclusive projects and
  when capital is constrained, the projects with
  the highest IRRs should be selected.
• Payback period represents the amount of time it
  takes for a project to recover its initial cost.
  The payback period decision rule specifies that
  all independent projects with a payback period
  less than a specified number of years should be
  accepted. When choosing among mutually exclusive
  projects and during certain times of tight
  capital constraint, the projects with the
  quickest paybacks are preferred.
• Profitability index (PI) is the ratio of the
  present value of change in operating cash inflows
  to the present value of investment cash outflows.
  A project that increases owners wealth has a PI
  greater than one. If PI is less than 1, a
  project should be rejected.

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Example Portfolio No Capital Constraints

• Cash Flows
• _______Millions of Dollars________
  NPV at 12
• Project Inv. C1 C2 C3 C4
  C5 _Millions of Dollars _IRR,
• A -50 30 20 10 8
  5 8
  21
• B -50 5 20 20 20
  10 3
  14
• C -30 5 15 20 5
  2 5
  19
• -130
• The firm has had a phenomenal year with oil
  prices above 40/bbl and has no capital
  constraints. Which projects should be approved?
  Answer all of them because all have positive NPV
  at 12, all have a good IRR, and the company can
  afford 130MM capital.

11
Example Portfolio Capital Constraints

• Cash Flows
• _______Millions of Dollars________
  NPV at 12
• Project Inv. C1 C2 C3 C4
  C5 _Millions of Dollars _IRR,
• A -50 30 20 10 8
  5 8
  21
• B -50 5 20 20 20
  10 3
  14
• C -30 5 15 20 5
  2 5
  19
• -130 but company budget now
  constrained to only 80MM in capital
• The firm has seen oil prices fall to 30/bbl and
  has instituted a capital constraint of 80MM/year
  capital. Which projects should be approved?
  Answer You would do Projects A and C for a
  combined 80MM investment as those two have the
  best IRRs and the best NPV combined total of
  13MM versus the combined NPV of 11MM for
  Projects A and B.
• Dilemma Project B is still commercial with a
  positive NPV and acceptable IRR but cannot be
  funded due to the investment portfolio capital
  constraint of 80MM. Selection of A and C has a
  higher combined NPV, thus maximizing shareholder
  wealth for the fixed amount of capital to invest.
  Project B is not competitive enough to add to
  the portfolio and will be re-considered in future
  years.

12
Discretionary Versus Non-Discretionary Projects
13
How Does The Gas Pipeline Project Equity Capital
Fit In Majors Capital Portfolios?

• Project is 18-20B to Chicago there will be
  project financing of 70 of this amount, or 14B
  debt secured by the line assets equity capital
  needed is 6B
• Assuming 6B equity that is needed, and assuming
  ownership of 1/3-1/3-1/3, BP,CP and EM would each
  need to allocate 2B in their capital portfolio
• The project will be constructed over 4 years, so
  the equity capital needed each year from each
  company is 0.5B when the project carries the
  debt
• Capital Equity Capital Of
  If
• Spending Needed For Line
  Annual 100 2003
• __Company 2003, B Per Year,
  B Budget Equity
  ROCE,
• ExxonMobil 15.5 0.5
  3.3 1.67B/11
  18
• BP 12.4
  0.5 4.0 1.67B/14
  16
• ConocoPhillips 6.2
  0.5 8.1 1.67B/27
  16
• Totals 34.1
  1.5 4.0 5.0B/15 17
• 
  (Times 4 years 6.0B equity
• Debt will be 14.0B)

14
What About The Level Of Debt For The Alaska Gas
Pipeline?

• Project is 18-20B to Chicago there will be
  project financing of 70 of this amount, or 14B
  debt secured by the line assets equity capital
  needed is 6B
• Assuming 14B debt that is needed, and assuming
  ownership of 1/3-1/3-1/3, BP,CP and EM would each
  need to assess impact of 4.67B in debt
• Debt Debt/
  Debt 2003
  At Year-end Equity Needed For Line
  Net
• __Company 2003, B Ratio
  B_____ Income, B
  
• ExxonMobil 9.8
  0.105 4.7
  21.5
• BP 19.9
  0.273 4.7
  10.3
• ConocoPhillips 15.6
  0.413 4.7
  4.6
• Totals 45.3
  14.1 36.4

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Sensitivity Analysis

• Low-side oil and gas price cases
• Some oil companies test all projects at 20/bbl
  or 3.50/MCF and must meet hurdle criteria at
  low-side pricing
• Different mix of projects within the capital
  budgeting portfolio
• Effect upon cash flows
• Effect upon total company value
• Effect upon debt/equity mix
• Best cash flow and earnings profile
• Shareholder wealth
• Final portfolio decided by executive management
  and BOD

16
Risk Assessment

• Forecasting risks
• Production
• Costs
• Taxes
• Other
• Exploration geologic risks
• Political risks
• Permitting risks
• Capital cost prediction risks
• Non-recourse project financing and debt
  assumptions
• Effect on supply/demand balance and pricing risk
• Projects must be resilient to risks

17
Risk Mitigation

• Sufficient front-end engineering and assessment
• Right technologies or new technologies
• Tighter control of capital and operating costs
• Government assurances and/or incentives
• Permitting
• Loan guarantees to allow better project financing
  interest rates
• Tax credits
• Low-side price risk protection
• Contract risk sharing mechanisms
• Taking on partners to spread the risks
• Different companies have different investment
  hurdle rate criteria and could be considered as
  partners

18
Commercial Versus Competitive IRRs

• Commercial
• IRR exceeds the cost of capital
• Competitive
• IRR and other criteria exceed the hurdle that
  creates the best mix of projects worldwide that
  maximizes shareholder wealth
• Comparison of performance between states and
  countries and between competitor companies
• Project IRRs may be commercial but not be
  competitive
• Corporations differ in IRR hurdle rates
• Financial performance
• Capital structure
• Segment of business and its available returns for
  projects

19
Conclusions

• Getting the Alaska Gas Pipeline Project into
  major oil companies approved capital portfolios
  is challenging
• The project may be commercial but is not
  competitive
• The project is discretionary vs.
  non-discretionary so has to meet tougher criteria
  than some projects
• Investors who desire a commercial
  rate-of-return are important to consider as
  investment partners, sponsors
• Multiple partners can mitigate risk on any one
  firm
• Government assurances of fiscal certainty and/or
  incentives can greatly reduce risks and ensure
  the project is competitive
• Sharing of risks by government is essential,
  including debt guarantees, low interest rate bond
  financing, low-price protection
• Local ownership adds incremental valuea possible
  key to bridging the gap between commercial
  and competitive

20
Sources And Exciting Reading

• Richard A. Brealey (London Business School) and
  Stewart C. Myers (MIT Sloan School of
  Management), Principles Of Corporate Finance,
  New York McGraw-Hill, Inc., 1991.
• Don Dayananda, Steve Harrison, Patrick Rowland,
  John Herbohn, and Ricard Irons, Capital
  Budgeting Financial Appraisal Of Investment
  Projects, Cambridge, England, UK Cambridge
  University Press, 2002.
• John Graham and Campbell Harvey (Duke
  University), Article How Do CFOs Make Capital
  Budgeting And Capital Structure Decisions?, New
  York Journal of Applied Corporate Finance, 2001.
• John A. Boquist, Todd T. Milbourn and Anjan V.
  Thakor, Article How Do You Win The Capital
  Allocation Game?, Cambridge, MA MIT Sloan
  School of Management, 1998.
• Bill Young, Article BP Amoco Policy Statement
  On The Use Of Project Finance, Waterton, MA
  Harvard Business School Publishing, 2003.
• Pamela Peterson, Internet Article Capital
  Budgeting Techniques, http//garnet.acns.fsu.edu,
  2004.
• Rick Mathis, Internet Article Corporate Finance
  Live, www.prenhall.com, 2004.
• Corporate Annual Reports, Analyst Presentations,
  and press releases for various companies.