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10/14/2004. Legislative Hearing - Capital Decisions And Budgeting. 2. Agenda . Importance of capital budgeting and allocation in a corporation to decide what projects to approveFramework of the capital budgeting processCapital projects portfolioInvestment criteriaSensitivityRisks and risk mitig
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1. Making Oil And Gas Upstream/Midstream Investment Decisions Presentation By:
Ken Thompson, President & CEO
Pacific Star Energy LLC
2. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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 d’Alene 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 ARCO’s approved capital portfolio
Past Manager of ARCO Corporate Planning to review and solicit approval for upstream, midstream and downstream investments
4. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 5 How Capital Budgeting Fits Into The Financial Planning Of A Corporation
6. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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.
10. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 10 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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 IRR’s 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 12 Discretionary Versus Non-Discretionary Projects
13. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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
15. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 15 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 18 Commercial Versus Competitive IRR’s 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 IRR’s 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. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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 value…a possible “key” to bridging the gap between “commercial” and “competitive”
20. 10/14/2004 Legislative Hearing - Capital Decisions And Budgeting 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.