MW Petroleum Corporation: A Valuation Approach on Real Assets

Valuation is the estimation of an asset’s value, whether real or financial, based on variables perceived to be related to future investment returns, on comparison with similar assets, or, when relevant, on estimates of immediate liquidation proceeds (Pinto, Henry, Robinson, Stowe; 2010). Correct valuation of real assets can present challenges to financial analysts. Different models can be used to arrive at the closest estimate of value and yet certain issues will always arise. This case attempts to tackle two approaches in real asset valuation: Discounted Cash Flow (DCF) analysis and the issues surrounding such, as well as the Black-Scholes Model for Real Options. Questions to be addressed in the study are:
1. Evaluate Amoco’s and Apache’s corporate objectives and strategies. Is it reasonable to expect that the MW properties are more valuable to Apache than to Amoco? What sources of value most plausibly account for the difference between buyer and seller? 2. Structure and execute a DCF valuation of all the MW reserves. How much are the reserves worth? Is your estimate more likely to be biased high or low? What are the sources of bias? 3. How would you structure an analysis of MW as a portfolio of assets in place and options? Specifically, which parts of the business should be regarded as assets in place and which as options? What kinds of options are present? Should this approach yield a higher or lower value that the DCF approach? 4. Execute the analysis you structured in Question 3, beginning with assets in place. How risky are the assets that underlie the options; i.e. how would you estimate SD for each? How much is the whole portfolio worth? 5. Assuming a sale goes through, how does Apache exercise each of the various options? When should it do so?
BACKGROUND

In a case prepared by Barbara Wall at the Harvard Business School, entitled MW Petroleum Corporation A, (doi:9-295-029; 1994), she stated that the 1980’s had been a difficult decade for the oil industry. Profitability of oil companies declined due to low prices; and most of these firms responded with cost-cutting measures. Many top companies divested their marginal properties, seeking to consolidate and rationalize their productive assets- one of which was Amoco Corporation. Amoco Corporation conducted an extensive review of its cost structure and profitability (p.2), leading to major restructurings to better focus on its core businesses.
The result of this was a divestment of the middle section of its assets along marginal curve. Morgan Stanley advised and assisted in the process, creating MW Petroleum Corporation – a new, free-standing exploration and production oil and gas company. MW was offered to a number of targeted international petroleum concerns, but the most attractive offer came from Apache Corporation. Apache Corporation was an independent oil and gas company based in Denver, Colorado engaged in exploration, development, and production of oil and natural gas. Their strategy, “rationalize and reconfigure” involves acquiring producing properties whose operations Apache could quickly control and make more efficient, producing significant cost-saving opportunities for the company. The sale of MW Petroleum provides such an opportunity for them. However, Apache must first carefully evaluate MW’s value to come up with a proposal that would be attractive for Amoco and profitable for Apache as well. CRITICAL ANALYSIS
1. Evaluate Amoco’s and Apache’s corporate objectives and strategies. Is it reasonable to expect that the MW properties are more valuable to Apache than to Amoco? What sources of value most plausibly account for the difference between buyer and seller?
AMOCO
APACHE
Growth Stage

MATURE
5th largest oil company in the U.S.
GROWTH
Operator of small-to-medium sized properties
Objectives
To increase profitability
To increase size/growth
Strategy

Divestment: major restructuring to better focus on its most attractive properties and opportunities (includes selling assets regarded as non-strategic)
“Rationalize and reconfigure”
-Acquiring producing properties whose operations they can control and quickly make more efficient
Yes, considering Amoco’s and Apache’s corporate objectives and growth stage, I can say that MW properties are more valuable to Apache than to Amoco. Amoco is already at the mature stage, and its current strategy is aimed at divestment (major restructuring to better focus on its core businesses) – MW properties no longer form part of such core businesses. Amoco is merely interested in selling MW for a profit, where as Apache sees it as an opportunity for growth and geographic diversification, to add further stability to the company, and to increase its reserves. Furthermore, Apache’s revenues are highly dependent on natural gas (current portfolio has an oil-gas ratio of 20-80), and with the increased volatility in natural gas prices, Apache would benefit from acquiring properties with a large concentration of non-gas assets. 2. Structure and execute a DCF valuation of all the MW reserves. How much are the reserves worth? Is your estimate more likely to be biased high or low? What are the sources of bias? At first, WACC and CAPM was attempted to be used as a source of cost of capital. However, for WACC, there is no available proportion of debt and cost of debt for MW. For CAPM, no available data seems to support the acceptable market return as compared to the 10-year government bond yield of 8.03%. Thus, the 13% discount rate used to compute the terminal value of MW petroleum was
used (line notes to MW Petroleum Projections #20).
ASSUMED COST OF CAPITAL: 13%
Using above assumed cost of capital, below DCF valuation shows the total value of all MW reserves. A separate DCF valuation was conducted for each reserve, with the total value summing up to MW’s total PV of 473.5M (refer to Exhibit 1 for complete details of DCF analysis). DCF of all MW Reserves
Proved Developed Reserves
383.84
Proved Undeveloped Reserves
40.79
Probable Reserves
41.47
Possible Reserves
7.42
Total Value of Reserves
473.51
DCF of Aggregated MW Projections
The sources of bias pertain to:
1. Cash Flow estimates were prepared by Amoco
2. Correct discount rate to be used (assumed rate was 13%, but it could be higher, which would then result to a lower PV for MW, and vice versa).
3. How would you structure an analysis of MW as a portfolio of assets in place and options? Specifically, which parts of the business should be regarded as assets in place and which as options? What kinds of options are present? Should this approach yield a higher or lower value than the DCF approach? MW can be thought of as a combination of assets-in-place and options. Assets-in-place pertain to properties that already provide cash flow. In this case, proved developed reserves would be most appropriate. The other reserves (proved undeveloped, probable, and possible reserves) are options. Currently, the firm has an option to delay until it is profitable to develop the reserves. Refer to Exhibit 2 for detailed Options Valuation computation.
Black-Scholes formula used is:
Real Options (@7years)
DCF
Proved Developed Reserves
383.84
(same value as DCF)
383.84
Proved Undeveloped Reserves
44.68
40.79
Probable Reserves
41.84
41.47
Possible Reserves
11.67
7.42
Total Value of Reserves
482.03
473.51
Real options valuation using the Black-Scholes model yielded a higher value compared to the DCF approach, since there is a real value attached with the firm’s ability to delay development. 4. Execute the analysis you structured in Question 3, beginning with assets in place. How risky are the assets that underlie the options; i.e. how would you estimate SD for each? How much is the whole portfolio worth? Refer to Exhibit 2 for Volatility computation
(weights of oil-gas ration given in the case and volatility taken from Exhibit 8 of MW Petroleum Case). 5. Assuming a sale goes through, how does Apache exercise each of the various options? When should it do so?
CONCLUSION
With the computed real option and DCF values, Apache should proceed with the purchase of MW Petroleum Corporation.
REFERENCES:
Equity Asset Valuation (Pinto, Henry, Robinson, Stowe; 2010)
MW Petroleum Corporation A, (9-295-029; 1994)