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Midland Energy Resources Essays

Midland Energy Resources Midland Energy Resources is a fully integrated energy company with operations in E&P, Refining & Marketing (R&M) and Petrochemicals. Capital budgeting at Midland is done using discounted cash flow method and weighted average cost of capital (rwacc). Corporate Weighted Average Cost of Capital, rwacc The primary use of the corporate rwacc is valuation (TV=FCF/(rwacc-g)). While the rwacc may be used for evaluating internal projects, the usage will be incorrect owing to the fact that the risk-return profile, debt structure and credit rating of individual projects/departments may be different.
Sometimes companies may want to repurchase stock if they think their stock undervalued and to do this valuation cost of capital is required. But this would be a short term valuation and hence the risk free rate of return to be used should be of short term. The corporate rwacc for Midland is 8. 55% (refer Ex-1). The following table enumerates the various assumptions: AssumptionValueRemarks Market risk premium5. 1% 5. 1% represents the 200 year average, with the lowest standard error of 1. 2%. Moreover this value is between the acceptable range of 4-6%. Risk free rate of return4. 8% 30 year long term treasury rates have been used for two reasons. A) Short term rates will eventually converge to long term rates. B) Energy projects are usually long term lasting for 10-30 years. Levered ? @ target D/E ratioRatio=42. 2% The target ratio defines the target D/E that the company requires to reach for the credit rating to be applicable. E&P Weighted Average Cost of Capital, rE&P-wacc Division wise WACC is essential as each business line has different risk-return profile. Since individual divisional stocks are not traded in the market, ? or E&P has been calculated by revenue based weighted average of pure-play E&P companies. However it is important to note that none of the companies (used in the exercise) have revenues comparable to that of Midland. Keeping this in mind the weighing is done on the revenue scale. Earnings scale is not the best indicator as the cost of operations in E&P sector differ widely from region to region and thus may induce error in estimation. The divisional rE&P-wacc is 8. 69% (refer Ex-2). R&M Weighted Average Cost of Capital, rR&M-wacc Similar methodology as used in the E&P has been used in R&M.
Revenue based weighing has been done as earnings depend heavily on government policies and environmental regulations of the country of operations. The divisional rR&M-wacc is 10. 48% (refer Ex-3). Petrochemicals Weighted Average Cost of Capital, rPchem-wacc Petrochemical rPchem-wacc has been calculated using a different methodology than used above for E&P and R&M. ? has been calculated using the weight of assets of three divisions. Since assets produce FCF, it is safe to assume that ? for Petrochemicals will be the residual of ? Firm and sum of ? E&P + R&M. The divisional rPchem-wacc is 1. 4% (refer Ex-4). Important points to remember when applying WACC rates DivisionWACC ratesRemarks E&P8. 69% This discount rate can be used for projects under E&P division. However it should be kept in mind that some projects may be different from others in terms of the risks they entail. For example a project in Afghanistan entails very high risk (due to socio-political environment) than a project in USA. Such projects are common in E&P business, and thus care should be taken while using 8. 69% as the discount rate (High risk will lead to higher discount rate, thus reducing the NPV). R&M10. 48%
This discount rate can be used for almost all projects in R&M division. However some parts of Europe require higher environmental regulations decreasing the returns from the project. Such anomalies should be factored in while discounting cash flows using WACC of 10. 48%. Petrochemicals1. 64% Petrochemical projects are usually unaffected by subsidies and government policies. Environmental regulations can increase the risk of delaying petrochemical projects as well decreasing returns. Before applying the DCF method with WACC of 1. 64% one should factor in all possibilities of under or over return (subsidy by govt).
Comparisons between Divisional WACCs Exploration & ProductionRefining & MarketingPetrochemicals Both the risks and returns in E&P projects are very high. World over 1 in 10 wells produce crude oil (the revenue from which is more than enough to fund the last and the next 10 wells). Due to this averaging effect the ? of E&P projects are comparatively lower (than R&M). However certain projects in politically unstable areas entail higher risks. Margins in E&P business are large and thus have a high tolerance to market movements or changes in crude oil prices.
Credit spread is moderate in case of E&P projects as compared to R&M and Petrochemicals, due to the fact that one crude oil/gas strike is enough to fuel the whole project. R&M projects are fairly stable ones unlike E&P projects. But due to low gross refining margins (return on each barrel of crude processed) and government control on selling price of distillates in most nations, the returns are low. Owing to the new environmental regulations, cost of acquiring site and other project level risks, the systematic risk levels of R&M projects have become higher in the last decade, leading to higher ? 1. 333) than E&P projects. Low margins in R&M projects lead to higher susceptibility to changes in crude oil prices, thus the market. Credit spread is highest in R&M owing to the many challenges these projects face and the low margins. However unlike E&P, R&M projects once setup produce constant cash flow. Petrochemical projects are hampered by similar challenges as R&M projects; however as petrochemical project is usually an extension of R&M project the risks are diversified.
Negative value of systematic risk for Petrochemical projects shows that they move opposite to the market and thus can be used as an offset for R&M and E&P projects during bad market conditions. Margins in Petrochemical projects are higher than in R&M. This is usually because there is no government regulation to cap pricing of lubricants. Lowest credit spread again signifies the low risk aspect of Petrochemical projects. Exhibit 1: Corporate rwacc Exhibit-2: E&P rE&P-wacc Exhibit-3: R&M rR&M-wacc Exhibit-4: Petrochemicals rPchem-wacc

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