Gulf Oil Analysis Essay

Statement of Problem & AlternativesGeorge Keller of the model oil colour high society of California (Socal) is attending how lots to decl argon oneself for disconnection Oil mass ( gulf), which is before long in the middle of a call upding war. disconnection is un leading to consider ask ins below $70 per shargon level though their piece of ground terms was $39 at the time Boone Pickens began purchasing regions in the hopes of a take everyplace. II. Statement of Facts and Assumptions Under the stress of James lee(prenominal), disjuncture pursued a twofold st pass judgmentgy. First, gulf renewed its focus on oil whereas in the past, disconnection had developed into an energy conglome treasure through with(predicate) various acquisitions of coalmines, uranium mines, and synthetic burn plants. These ventures would be de-emphasized going forward. For second wear of the strategy, disjuncture planned to implement a policy of increased expenditures on geographic ex pedition and development (E&D).During the years leading up to the takeover attempt, Gulf more than bivalent its explo dimensionn outlays. While Gulf was proceed with its ambitious E&D program, the echt determine of oil and natural artillery declined from 1982 through 1983. As 1984 began, almost wholly industry experts were in agreement that the price of oil (in constant dollars) was non judge to change for the following 10 years. Lee trimmed exploration expenditures in 1983 in response to these changing fundamentals. Even at the reduced level, spending for exploration in real terms equaled or exceeded that of any year before Lees arrival except one. Based on this picture, Socal needs to range Gulf. There atomic number 18 several sources of value that can be considered the value of Gulfs fossil oil militia the represent savings cerebrate to the immediate suspension of Gulfs E&D program the tax benefits associated with additional leverage the value added by shortening the recovery lag and the value of any adverse effects receivable to the acquisition of Gulf by a competitor1.In addition to calculating Gulfs reserve value, Socal needs to be mindful of its competition. Both Atlantic Richfield Company (ARCO) and Kohlberg KravisRoberts & Company (KKR) are financially peculiar(a) should Gulfs touch price continue to escalate. It would be difficult for ARCO to bid more than $75.00 per share assumption that its resulting debt-to- great ratio would exceed 60% (historicly high). KKR is in a similar situation. Mesa, led by Pickens, currently holds 13.2% of Gulfs stock at an average purchase price of $43. In order to bid successfully, Mesa would hasten to borrow many times their solve cost. With banks queuing up to lend money to offer an $80 share price (or higher), Socal will have to take on a considerable amount of financial leverage.III. compend Although there are multiple sources of value, this abridgment focuses on valuing Gulfs reserves, p resumptuous E&D activities will halt perspective acquisition (liquidation value). The critical elements that come into the valuation of Gulfs reserves are Acquisition date Since we are trying to establish why Gulf became so valuable within a short period of time from when their share price was $39 to when a negligible bid level of $70 per share was established, its appropriate to use January 1st, 1984 as the first year Socal imitation will power of Gulf. Reserve life Assumed a reserve-to-production ratio of 121. It takes approximately 4 years for the stream to come online and the field, at a time online, is productive for another 7-10 yrs. Based on this ratio, Gulfs reserves are depleted at a rate of 192.75 million barrels per year over a 12-year period. Inflation rate 4.67% ground on the average pretentiousness place lionized mingled with 1982 and 1983.There was an outstandingly high rate of ostentation between 1978 and 1981 so years prior to 1982 were not included. H owever, a sensitivity digest was performed to observe the effects of a higher inflation rate based on historic averages (see break 1). Oil sales Oil price is expected to stay at $22.42 in constant dollars (prices are adjust for inflation). Production be Production cost per barrel is expected to stay at $6.48 in constant dollars (prices are set for inflation). See Exhibit 2. Exploration cost The capitalized portion of past extraction costs are recognized as dispraise when the corresponding oil is produced.These depreciation write offs set off from year to year based on historical costs. See Exhibit 3. working(a) capital For this analysis, working capital is take for granted to be negligible given that the analysis is geared towards determining Gulfs reserve value. Capitalexpenditures For this analysis, capital outlays are assumed to be zero given that the analysis is geared towards determining Gulfs reserve value. Gulfs E&D program ceases post acquisition.Discount rate Gulf s weighted average cost of capital calculated to be 15.35%. See Exhibit 4. Utilizing a discount rate of 15.35% and the assumptions describe above with a put down notes flow model (see Exhibit 6), Gulfs reserves are worth(predicate) an estimated $80.73 share ($16,120.69M)2. Adjusting the inflation upwardly to 8.37%, Gulfs reserves are worth an estimated $96.16 per share ($15,895.35M). Since Socal would be taking on additional debt, its important to scar whether or not future free specie flows cover the incremental recreate expense. Exhibit 7 shows that future notes flows easily cover interest expense associated with up to a $90 per share purchase price.Additionally, taking the free cash flow derived in Exhibit 6 (basis for an $80.73 share price) and discounting based on Socals WACC (16.96% see Exhibit 5), we arrive at a reserve valuation of $75.56 per share. Adjusting inflation upwards to 8.37% and discounting at Socals WACC, Gulfs reserves are worth an estimated $89.65 per share.3 IV. Recommendations Based on the analysis, a bid of $75.56 per share for Gulf is appropriate. A bid above this price would result in a loss for Socal shareholders. This price is excessively above the $75 threshold, which if offered by ARCO or KKR would send their leverage above historical highs (greater than 60%). Given the valuations sensitivity to the assumed inflation rate, discount rate, and recovery lag, $75.56 represents a pessimistic valuation giving Socal focal point room to adjust its bid upwards if necessary.These estimates do not consider the mishap of recovering Gulfs misrelated fixed assets. Its important to note, the analysis is very sensitive to the discount rate assumed, recovery lag, and the inflation rate.