Gulf Oil Analysis Essay

Statement of Problem & AlternativesGeorge Keller of the Standard Oil Company of California (Socal) is considering how much to request for disjuncture Oil great deal ( disjuncture), which is currently in the middle of a bidding war. Gulf is unwilling to consider bids below $70 per shargon even though their make out cost was $39 at the time Boone Pickens began purchasing shares in the hopes of a takeover. II. Statement of Facts and Assumptions Under the direction of James Lee, Gulf pursued a twofold st prizegy. First, Gulf renewed its focused on oil whereas in the past, Gulf had developed into an energy conglomerate through various acquisitions of coalmines, uranium mines, and synthetic fuel plants. These ventures would be de-emphasized going forward. For second part of the strategy, Gulf planned to implement a policy of increased expenditures on exploration and development (E&D).During the age leading up to the takeover attempt, Gulf more than doubled its exploration outlays. Wh ile Gulf was continuing with its ambitious E&D program, the received price of oil and instinctive gas declined from 1982 through 1983. As 1984 began, almost all industry experts were in agreement that the price of oil (in constant dollars) was not expected to change for the succeeding(a) 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 every year before Lees arrival except one. Based on this picture, Socal needs to value Gulf. on that point are several sources of value that can be considered the value of Gulfs petroleum militia the cost savings related 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 perverse effects due to the acquisition of Gulf by a competitor1.In addition to calculating Gulfs reserve value, Socal needs to be aware of its competition. Both Atlantic Richfield Company (ARCO) and Kohlberg KravisRoberts & Company (KKR) are financially limited should Gulfs share price continue to escalate. It would be difficult for ARCO to bid more than $75.00 per share given that its resulting debt-to-capital ratio would exceed 60% (historically high). KKR is in a similar situation. Mesa, led by Pickens, currently holds 13.2% of Gulfs gestate at an average purchase price of $43. In order to bid successfully, Mesa would have to borrow many times their net worth. With banks queuing up to add money to support an $80 share price (or higher), Socal will have to take on a considerable amount of financial leverage.III. Analysis Although at that place are multiple sources of value, this depth psychology focuses on valuing Gulfs reserves, assuming E&D activities will cease post acquisition (liquidation value). The critical elements that infix into the valuation of Gulfs reserves are Acquisition date Since we are trying to establish why Gulf became so valuable at heart a short period of time from when their share price was $39 to when a minimum bid level of $70 per share was established, its take over to use January 1st, 1984 as the first year Socal assumed ownership 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, once 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% based on the average inflation rates observed between 1982 and 1983.There was an unusually high rate of inflation between 1978 and 1981 so years prior to 1982 were not included. However, a sensitivity analysis was performed to observe the effects of a higher inflation rate based on historical averages (see Exhibit 1). Oil sales Oil price is expected to stay at $22.42 in constant dollars ( prices are alter for inflation). Production costs Production cost per barrel is expected to stay at $6.48 in constant dollars (prices are adjusted for inflation). See Exhibit 2. Exploration costs The capitalized portion of past extraction costs are recognized as dispraise when the corresponding oil is produced.These depreciation expenses vary from year to year based on historical costs. See Exhibit 3. Working capital For this analysis, working capital is assumed to be trifling 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 Gulfs weighted average cost of capital calculated to be 15.35%. See Exhibit 4. Utilizing a discount rate of 15.35% and the assumptions outlined preceding(prenominal) with a impoverished cash in flow model (see Exhibit 6), Gulf s reserves are worth an estimated $80.73 share ($16,120.69M)2. Adjusting the inflation upwards 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 check whether or not future free cash flows cover the incremental interest expense. Exhibit 7 shows that future cash 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 nonplus 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 also above the $75 threshold, whic h 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 management room to adjust its bid upwards if necessary.These estimates do not consider the possibility of recovering Gulfs unrelated fixed assets. Its important to note, the analysis is very sensitive to the discount rate assumed, recovery lag, and the inflation rate.