Question

The price of oil is currently $50 per barrel (bbl), but the long-run mean is believed to be $75, and the annual speed of mean reversion is 15%. An oil drilling company wishes to value a prospective new property. The financial details are below:

a. Production levels will start at 500,000 bbl for the first 10 years, and will drop to 250,000 bbl for the next 10 years, at which time the oil will be exhausted.

b. The fixed costs of producing the oil will be $5,000,000 per year.

c. The variable costs of producing oil will be $10 per barrel

d. The discount rate is 9% per year, and the first cash flow is in one year. What is the value of the oil well today?

What is the value of the oil well today?

Answer 1

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5-10	Year 11-20
Selling price of oil (with 15% reversion) (a)	$             50.00	$             57.50	$             66.13	$             75.00	$             75.00	$             75.00
Production level (b)	500,000	500,000	500,000	500,000	500,000	250,000
Revenue (a*b)	$     25,000,000	$     28,750,000	$     33,062,500	$     37,500,000	$     37,500,000	$     18,750,000
Less: Variable cost ($10/barrel)	$       5,000,000	$    5,000,000	$       5,000,000	$       5,000,000	$       5,000,000	$       2,500,000
Less: Fixed Cost	$       5,000,000	$       5,000,000	$       5,000,000	$       5,000,000	$       5,000,000	$       5,000,000
Net Cash flow	$     15,000,000	$     18,750,000	$     23,062,500	$     27,500,000	$     27,500,000	$     11,250,000
Discount rate (9%)	0.917431193	0.841679993	0.77218348	0.708425211	3.177937824	2.710887968
PV of Future cash flow	$     13,761,468	$     15,781,500	$     17,808,482	$     19,481,693	$     87,393,290	$     30,497,490
Value of Oil well today	$   184,723,922