Oklahoma Gas Company to Explore Oil Wells in Texas

Case Type: merger & acquisition (M&A); pricing & valuation; operations strategy.
Consulting Firm: Schlumberger Business Consulting (SBC) first round full time job interview.
Industry Coverage: oil, gas, petroleum industry.

Case Interview Question #01110: The client Oklahoma Gas Company (OGC) is a medium-sized private company that has a rich history of drilling and producing natural gas wells in the state of Oklahoma. They possess a diverse, and they believe valuable, set of land assets where more natural gas wells could be drilled.

The company OGC is well capitalized, but profits have been falling in the last few years and are projected to be negative next year. One of the key drivers in the drop in profitability is the price of natural gas, which has dropped substantially, thanks in part to companies like OGC, that have perfected unconventional drilling techniques and have subsequently oversupplied the North American natural gas market. Natural gas prices are currently at a five year low.

Recently, a larger competitor has approached the management of Oklahoma Gas Company about acquiring OGC for $250 Million. Management would like your help in assessing the offer as well as identifying alternate strategies. What would you recommend?

Additional Information: to be provided upon request

* Present Valuation of OGC is not readily available. Tell the candidate that more data on the topic will become available later.
* Costs have remained stable.
* While Natural Gas demand fluctuates seasonally, the annual demand has been stable over the past few years.
* Land Assets = OGC owns 100% of the mineral rights of their land.
* While regulations have changed, and may continue to change, they have yet to have a large impact on OGC’s business.
* OGC has not drilled oil wells in the past, but would likely have the competency to do so in the future.
* Natural gas and oil prices are volatile and out of the control of OGC. Future prices are difficult to predict.
* The client OGC currently only operates in Oklahoma.

Possible Answers:

The candidate will likely dwell on the acquisition offer. Guide them away from this, as it will only serve as the baseline for option selection. The objective of the case is for the candidate to evaluate viable options before recommending a course of action.

Ideally the candidate creates a basic profitability framework, and focuses on what options the client company OGC has.

Note: This case is meant to be adaptable. The interviewer can make it more or less difficult at anytime based on their discretion.

Question #1: what alternate strategies does the client OGC have?

Potential Options for OGC:
1. Explore drilling oil wells (Obvious – if the candidate is aware of booming shale oil revolution in the US or current price of oil)
2. Continue drilling natural gas wells in the areas that they own
3. Sell some land assets
4. Acquire more land assets and drill gas wells elsewhere
5. Acquire smaller competitor
6. Go Public
7. Sell for $250 M
8. Negotiate the $250 M offer upwards

Guide the candidate towards the following three options:
(1) continue drilling natural gas wells,
(2) drilling oil wells,
(3) considering the acquisition offer of $250M

While continuing to do what is NOT working may seem counterintuitive, OGC is very good at drilling natural gas wells. Key takeaway from this case is that all the assumptions and projections made by OGC and the candidate are based on highly volatile commodity prices.

Question #2: OGC has found an oilfield in South Texas that it can acquire and drill on immediately.

The candidate should begin asking for data to analyze the three options on a present value (PV) basis.

Option 1: Continue drilling Natural Gas wells
* The present value of all OGC’s currently producing natural gas wells is $50 M
* The Price of natural gas is $3.00/mcf (thousand cubic feet)
* Cost of capital = 10%
* Cost of acquiring and drilling the additional natural gas wells is $50 M — Each well will come online in the Year 0 and stop producing after Year 2.
* Year 0 natural gas production projected = 40,000 mmcf (million cubic feet — unit change)
* Year 1 natural gas production projected = 30,000 mmcf
* Year 2 natural gas production projected = ~17,000 mmcf
* At a price of $3.00/mcf, this gives you a total PV of $194 M
* PVs:
– Year 0 = $3.00 * 40,000,000 – $50 M drilling cost = $70 M
– Year 1 = $3.00 * 30,000,000 / (1+10%) = $81.8 M
– Year 2 = $3.00 * 17,000,000 / (1+10%)^2 = $42.1 M
– Total PV = $70M + $81.8M + $42.1M = $194M. Note: A $0.25 increase in the price of Natural Gas would mean the wells’ PV is greater than $210 M

Note: This case is meant to be adaptable. The interviewer can make it more or less difficult at anytime based on their discretion.

Option 2: Drilling Oil Wells

If the candidate got the the PV for Natural Gas correct, begin giving them the data below. Go straight to last bullet if they struggled.
* Current price of oil is $120 (NOTE: historically high $)
* The cost of acquiring and drilling all necessary oil wells in the oilfield is $100 M
* Cost of capital = 10%
* Production horizon for each oil well is 10 years – at this point candidate should realize that the math is too much, and even if they do the math, the value is far too dependent on the price of oil.
* State that projected PV of the South Texas oilfield is $210 M.

Candidate now has three values:
(1) $194 M to continue drilling natural gas wells (+$50 M in legacy gas well),
(2) $210 M for drilling oil wells (+$50 M in legacy natural gas well),
(3) $250 M to sell the company.

Conclusion: At this point they will likely give a firm answer that acquiring the new oilfield in South Texas and drilling oil wells is the correct path forward.

Bonus Questions

The interviewer should then push back:
* Is OGC sure they can successfully drill oil wells, out of state, with no experience?
* Where did the $210 M value come from – projecting oil recovery is very difficult?
* Drilling costs are highly variable, likely to run over?
* Finally, how sure are they about forecasting prices of oil and natural gas?

The correct answer to the case is that there is not enough information given to provide a firm answer at this point. Thorough price forecasting (for both oil & natural gas) needs to be done. A counter offer should be made. OGC’s competency to drill and produce oil wells should be reviewed. A second opinion should be taken on the PV projection of the oilfield. Assumptions play a huge role in the valuations.

Note: candidate may push back regarding the chances that natural gas prices rise because of the oversupply situation. As we see in reality today, large oil & gas companies will stop drilling for gas when prices drop, and gas wells inherently produce for shorter lifespans, thus a significant change in the supply of natural gas is possible.