Oil & Gas Management

SR Limited – Scenario

Read all the information provided in the Case Study briefing notes before you begin, as well as conducting your own research and evaluations. Please note that the Case Study notes contain more information than you need, or might use, when compiling your report.

SR Limited and the personnel named in the Case Study are fictitious, and any similarity to oil organizations and people is accidental.

You have been appointed as a management consultant at the start of August 2014 to SR, an oil/gas exploration and production company.

You work as a management consultant with expertise in the oil and gas exploration and production industry (E&P). The board of SR is faced with a number of issues which it is seeking your advice on before they decide what to do. You should summarize the underlying issue, provide analysis of the issue and give your own detailed recommendations as to what you think the board should do.

Where the issues have ethical dimensions the board wish you to explain the underlying ethical issue and indicate the possible courses of action in order to remain ethical as a business.

License application results

Of the four license applications applied for earlier in the year SR has won the right to test drill on three different fields (Edwina, Felicity and Georgia). It was unsuccessful on the fourth (Hetty) where it is rumored that the license was awarded to an independent E&P business with a very relaxed attitude to “facilitation payments”. The SR share price immediately rose on the news to a new record level of US$35.

Charles Lincoln is delighted with the news but even he is unsure whether SR has the financial or managerial capacity to test drill all three sites. No contracts have yet been signed but the license offers are open for acceptance for a two-week period only. In all cases test drilling must be commenced by 31 March 2015 and all test-drilling operations are expected to last 12 months. All the sites are in shallow water and all are within SR’s technical capability.

Hubert Polk (CFO) is off sick and not expected to be fit for work for about a month, which is too late to do any meaningful work on the financing for the new licenses given the two-week acceptance period mentioned above. Charles Lincoln wants to know how much the business could raise from a rights issue and from loans, and how much the business will generate in cash in the year to 31 March 2015. The test drilling expenditure required has been estimated by Gerald Taft as part of the tender process for the licenses and these calculations are shown in Appendix 1 on page 7.

Charles Lincoln has done a little research and found two newspaper articles, which he believes reflect the current thinking of the various providers of finance involved. These articles are shown in Appendix 2 on page 8. He has also made some assumptions about the financial performance of SR for the year to 31 March 2015, which he had previously agreed as reasonable with Hubert

Polk before he went off sick (and before the license application results were known) and these are shown on Appendix 1 on page 7.

Farm out offer

Regardless of the decision whether to test drill all three sites the SR board is clear that SR will lack the financial capacity, and the managerial and productive capacity to bring all three wells into production. Accordingly SR is considering an interesting farm out offer from a business called Drill Well (DW).

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Normally a farm out deal is negotiated at the time a field is ready to be farmed out. In this case DW has offered an option payment, payable now, which will give it the right but not the obligation to produce the oil in field Georgia from 31 March 2016 (which is the expected date that test drilling will have been completed and production work could start). If Georgia has commercial reserves then DW can extract them should they wish, but if Georgia proves to be barren of oil and gas the option payment is kept by SR. In this way the option deal carries risk for DW.

The offered option deal is as follows:

1. The option payment is US$10m payable on 31 August 2014 and is not repayable unless any of the conditions below are breached.

2. The field test drilling must be completed and reserves independently proven by 31 March 2016. For every complete or part month this date is exceeded SR will have to pay US$1m without limit.

3. DW requires presence at the board meetings of SR whenever the Georgia field is on the agenda. This is intended to keep DW up to date with progress and ensure DW’s interests are protected.

4. The US$10m is to be held in an escrow account, being released in tranches as follows: US$2m on successful signing of the Georgia test drilling licence with the government in question. US$2m on commencement of actual test drilling and 100m below sea bed drilling depth has been achieved. US$6m once the test drilling is completed and the extent of any reserves is established.

5. The current average normal price for buying proven reserves is around US$11m per MMbbl (or MMboe for gas), but DW wants a 10% discount. The geologist reports indicate that the Georgia field could have between 8 and 10 MMbbl/MMboe of oil and gas. The option contract will fix the price that DW pays at US$11m less 10% regardless of what happens to oil and gas values over the intervening period. In this way DW will make a lower overall margin on the extracted reserves but will have lower risk since the reserves will be proven. These figures assume a normal mix of oil and gas is discovered in the field.

Protest by the Care Green Party

The SR head office was targeted last week by a protest about the use of finite fossil fuels. This was a co-ordinated attack against the industry rather than SR alone. It sought to highlight the lack of interest E&P businesses have in sustainable development of renewable energy sources. Twelve other E&P independents were also targeted at the same time. The local and national news agencies picked up the story and although SR was not mentioned in the broadcast it was considered bad publicity for the industry in general.

Charles Lincoln was unimpressed, as he couldn’t park his brand new BMW 650i in his normal spot and had to walk 400 meters in the rain. “Finding oil and gas is what we do and the world should be grateful for that!” he said “without oil and gas we would all be walking and getting wet, and by the way sitting in the dark!” he went on.

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Outsourcer – BoringHolesUK

Since SR outsources all of its production work to others, the control of the outsourcers is considered a vital role for SR. Spot checks are carried out on a regular and rotational basis. These are carried out by a SR supervisor who checks the evidence that safety controls have been performed properly and on time. All SR’s supervisors are experienced in this task.

BoringHolesUK Limited is the chosen outsourcer at the Apache field and has been working with SR from the start. They have a good reputation and have always worked well within SR’s and industry regulations.

The Apache Field is off the coast of an African country that has recently been the subject of considerable unrest. The government is under attack by militants and the country is now considered to be a very dangerous place to be for everyone. Consequently BoringHolesUK has started to find it difficult both to retain staff and to recruit replacements. This has put considerable strain on its systems of control and operations.

One of SR’s supervisors, whilst on a spot check control visit, noticed irregularities with the control log records. It appeared that the records showed the signature of a Mr. Adam Green as carrying out the checks, but the payroll records revealed that Mr. Green had left BoringHolesUK two months previously. Although no accidents had occurred the control in question directly concerned the flow of oil and would normally be considered a vital safety check.

On investigation it appeared that Mr. Green’s signature had been forged, as a suitably qualified replacement engineer could not be found immediately after he left. A new engineer has now been offered the job and will start in one month, after he has served his notice period with his existing employer. BoringHolesUK’s management are insistent that the control was carried out to the best of their abilities and are very apologetic about the cover up.

A routine government check of procedures is due in three weeks’ time when a government official will visit the field. Zachary Madison, in particular, is very worried about this visit. He has suggested that apart from doing everything SR can to check things are now safe SR should conceal its knowledge of the past irregularities mentioned above. He argues that since there were no actual accidents SR should accept BoringHolesUK’s assurances that the controls were carried out properly and hence focus on the future not the past.

SR’s long-term future

Charles Lincoln surprised the board recently by suggesting that SR needs to consider its long-term future with specific regard to the inherent lack of sustainability of fossil fuels. SR’s existing reserves from oil fields already in operation will last around seven more years and the new fields do not look like adding significantly to that figure (although more will be known once test drilling is completed).

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Your Coursework Assignment Brief

Charles Lincoln has asked you – as the management consultant – to write a Report paper outlining the various challenges faced by SR Limited for discussion at Board level.

This should be a high-level Report, summarizing the various issues facing SR, provide some initial analysis of the problems to guide the Board of SR in considering what action to take next. Your report will therefore contain your recommendations, supported by robust and objective argument, of what to do next, which might be in the form or a more detailed investigation.

The major challenges facing SR, and which you are expected to discuss, include: raising the necessary finance to test drill all the new fields; consideration of the farm out offer from Drill Well; SR’s dependency on fossil fuels and lack of future sustainability; corporate governance and corporate social responsibility in light of the issues with BoringHolesUK.

Prepare a 2,500-word Report that prioritizes, analyses and evaluates the issues facing the board of SR, based on the issues highlighted in this scenario.

There is no requirement for a full financial analysis of SR Limited – remember, this is a high-level Report that summarizes the issues facing the Board.

Whilst the Case Study notes contain significant amounts of data and information, Students are recommended to supplement this with outside research and sources.

Your Bibliography must contain all external reference sources; there is no need to cite the Case Study material within the Bibliography.

Total marks for assignment: 100

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SR: Appendix 1 to the briefing paper

Assumptions about the financial performance of SR’s existing business in the year to 31 March 2015 as agreed between Charles Lincoln and Hubert Polk

Revenue

Oil and gas volumes from Apache and Barracuda will be the same as in the year to 31 March 2014. Colombian will grow in volume terms by 30% for both oil and gas. Oil and gas prices are very difficult to predict but an average 5% increase is widely accepted as likely. The year to 31 March 2014 average oil price is to be taken as US$109.80 per barrel for all fields and the gas price to be US$18.25 per barrel equivalent.

Gross profit

The higher prices and the economies of scale from extra Colombian volumes will push up the GP% to 48% on average in the year to 31 March 2015.

Distribution and administration costs will remain unchanged from the 2014 accounts.

Finance costs (net) will remain at 2014 levels.

Working capital – The level of inventories will reduce by US$10m, the level of receivables will increase by US$2m but the level of payables will increase by US$5m due to a longer payment period being agreed and taken.

Taxation will now be payable on all profits at 24% since the operating tax losses have been used up. No deferred tax change is expected. Tax is payable 9 months after the year end.

Non-current assets: To maintain existing assets to an acceptable safety level it is expected that US$30m will have to be spent. The depreciation charge is expected to be US$28m.

Dividends will have to commence in the financial year to 31 March 2015 as Orit had indicated that at a recent shareholders meeting. An initial US$10m was suggested.

Predicted cash needs for wells Edwina, Felicity, Georgia, Hetty:

Edwina Felicity Georgia Hetty Test drill costs US$ million 20 25 18 25

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SR: Appendix 2 to the briefing paper

The following is a reproduction of two articles that appeared in the business pages of a reputable newspaper last month. Article 1

Shareholders make their views known!

This week was an exciting week on the London Stock Exchange with two high profile rights issues floundering on the rocks of disappointment.

Frolgas (a gas fracking company) upset its previously happy shareholders with a cash call that proved a step too far. It asked for one new share to be bought for every two already held and offered no discount on the existing market value. A representative of the institutional investors commented:

“We are not a bottomless pit, nor are we fools. A one in two request is just too much of an extra investment; it represents a 50% increase in our already significant investment. With all the uncertainty surrounding the future regulation in the fracking industry we urge a little more caution. Equally we wanted a discount on the existing market value of at least 15%, we have costs as well and champagne isn’t getting any cheaper you know!”

“They have certainly fractured our friendship with this” he added with a smile.”

Exactly what was acceptable was not made clear but one in four generally works well. The representative was right about the champagne prices.

Article 2

Banks refuse to dig deep in the murky waters of E&P

The major banks are short of funds and coming under increasing pressure not to take extreme risks. Such is the claim of banking regulator, the Bank of England. Accordingly the Bank of England has issued guidelines on the maximum loans that would normally be seen as acceptable in the E&P industry.

For expanding E&P businesses adding more fields is a costly business and one that strains the cash flow. A bank should be cautious about total lending being more than three times the operating profits of the latest published accounts. Existing loans must be accounted for, so that overall debt levels remain within the above acceptable limits. There are always exceptions but there would need to be a convincing case of growth, proven reserves and solid cash control before more should be given.

The banks have to balance the need for the world economy to grow to provide jobs and prosperity and the need to protect their own business risk profile. This guidance is an attempt to provide both that balance and a degree of certainty needed by many ambitious E&P businesses.

• The Assignment should be written in the third person

• The Assignment should NOT contain an Abstract, Executive

Summary, a Table of Contents, nor a re-statement of the

Assignment Brief

Clear demonstration of rigorous research from recognised authoritative sources.

Audience focus. Meeting the deliverables.