Kazakstan Oil Field Opportunity

 

You are working for Exxon and you have received the attached spreadsheet describing a prospective oil field in Kazakstan.  Previously, the Soviets explored in the area and defined the field, but it was never developed due to the fall of the USSR.  The geologists report back that they are reasonably confident in their estimates of what the field will produce each year.   Thus there is negligible geologic risk.  Furthermore, they have provided their best estimates of the cost of transporting the oil.  The field is on the west side of the Caspian, and it is very costly to get the oil to a Mediterranean port.

 

  • Assuming that the estimates of oil reserves and projected costs are correct, your job is to evaluate whether this is a viable project for Exxon.  Your company has no other operating experience in Kazakstan.   The net present value depends critically on the assumed discount rate. The political risk of expropriation is an important factor.

 

  • The state owned Kazak Oil company will take a 50% share of your production and pay you a fixed fee of $5 per barrel for their share of the oil.  In addition, you are liable to pay the 50% corporate income tax. The estimates for production and expenses are in the following spreadsheet.
  • Currently, for domestic oil fields, Exxon applies a 9% hurdle rate of return to value its domestic projects.

 

A.

1.      Should political risk be calculated in the discount rate OR in the cash flows on this project? Discuss.

2.      If you were to use the discount rate approach, justify the pros and cons of 3 methods of calculating the international cost-of-capital. You may have to defend your choice in the face of severe criticism from your superiors. Which model do you choose!

3.      Show your calculations for the cost of capital. For each of the 2 methods. (Hint: show all the main inputs to your equations.)

4.      Discuss how will you incorporate risk into the project. Given your hurtle rate what is the expected cash flows from the project.

5.      How does the relation between oil prices and discount rates affect your analysis.

 

B. Now assuming all of the same information is true, assume instead that you are a startup oil company using your own funds.  How would your answer to A. 2 and 3 change above, if at all. Justify your conclusion.