Making Oil And Gas Upstream/Midstream 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 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 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 Legislative Hearing - Capital Decisions And Budgeting

5. How Capital Budgeting Fits Into The Financial Planning Of A Corporation 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 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 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 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. Legislative Hearing - Capital Decisions And Budgeting

10. Example Portfolio – No Capital Constraints Cash Flows _______Millions of Dollars________NPV at 12% Project Inv.C1C2C3C4C5 _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. Legislative Hearing - Capital Decisions And Budgeting

11. Example Portfolio – Capital Constraints Cash Flows _______Millions of Dollars________NPV at 12% Project Inv.C1C2C3C4C5 _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. Legislative Hearing - Capital Decisions And Budgeting

12. Discretionary Versus Non-Discretionary Projects 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, $BPer Year, $BBudgetEquityROCE,% ExxonMobil 15.5 0.5 3.3% $1.67B/11% 18% BP 12.4 0.5 4.0% $1.67B/14% 16% ConocoPhillips 6.20.5 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) 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, $BRatio $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 4.74.6 Totals $45.3 $14.1 $36.4 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 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 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 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 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” 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. Legislative Hearing - Capital Decisions And Budgeting