Discussion of Sensitivity of Each option to the Production Profile

Discuss about the Oil and Gas Accounting.

Sensitivity analysis refers to the management tool to analyze the project scenarios by testing the factors of critical variables and non- critical variables in terms of overall organizational profitability. In order to consider the capital budgeting projects, management of the company uses sensitivity analysis along with the ascertainment of responsiveness for project variables to calculate NPV (Galvez, Ordieres-Meré and Capuz-Rizo2015). In the present case, Rick considered three production profiles P90, P50 and P10 under three options for which net present value and payback period has been calculated. As per the calculation, net present value of the production profile P90 reflects negative value under all the three options while the payback period of the project is longer than other production profiles. It has been stated that the affect of inflation rate 2.0% during each of the year involves total investment amounted to $561 million (refer excel sheet, option3 P90), which is higher than the total projected cash flows by more than 50%. Therefore, the production project P90 incorporates higher sensitivity risk and it will not be acceptable.

Further, production profile P50 and P10 involves positive net present value in the all the three options whereas the duration of payback period is shorter than that of project P90. In case of project P50, net present value under option 1 has been the highest together with the lowest payback duration. Besides, the amount of net present value under option 3 reflected lowest value along with the longer payback back period 1.74 but the internal rate of return reflected higher rate 25.38% (refer excel sheet, option3 P50). A project with shorter payback period and higher internal rate of return is considered to be feasible and profitable (Sánchez 2015). On the contrary, net present values in case of third profile P10 is highest in all the three options compared to the other two profiles while the payback period in shorter in the first option 1.30 and the internal rate of return reflected 32% (refer excel sheet, option3 P10). Accordingly, risk factors in the first and second production profiles, P90 and P50 are high than that of projection profile P10.

Under the option, P90 total cost of construction reflected $307 million (refer excel sheet, option3 P90) that incorporates 2% inflation rate together with the interest cost for the borrowed money at the rate of 8%. In addition, total payment for the project includes $399 million (refer excel sheet, option3 P90) while the net present value amounted to $170 reflected negative balance and the payback period measured was 2.53. On the contrary, the project involves 5.66% internal rate of return while 15.36% modified rate of return that reflects higher risk and lower profitability. Considering the project P50, net present value reflected positive value with the payback period 1.74 under option 3 while the internal rate of return has been 25% (refer excel sheet, option3 P50). On comparing the price of oil and natural gas including inflation rate, it can be analyzed that the price sensitivity of this option together with the cash flows is lower and the risk factors of the variables are also lower (Lee and Lee 2015). Further, net present value of the project P10 is highest with the shorter payback period together with the highest internal rate of return 32.55% (refer excel sheet, option3 P10), which reflects lower sensitivity and lower risk factor in the project variables.

Sensitivity of each Option to the Prices of Oil and Natural Gas

Analysis of price risk can be done in consideration with the extensive risk in association with the factors of high- frequency and low severity as well as the returns of extensive cash flows. Analysis of price risk is considered in terms of aggregate amount of cash flows incorporating the time value of money to determine the present value of future cash flows. Profitability index as well as discounted payback period technique can be used to analyze the price risk more extensively. Discounted payback period involves time value of money to determine the duration of recovering the invested cash flow hence, it provides more appropriate outcome (Gorshkovet al. 2014). Besides, profitability index determines the sensitivity of price risk by considering present value of cash flow and investment and the project is considered god if the resultant index is greater than 1.

Intangible considerations that might affect the recommendation of Rick to consider proposed projection profiles includes qualitative considerations, technical considerations, managerial considerations and economic considerations. Qualitative consideration affects the acceptance or rejection feature for strategic investments that determines the long- term capability to incur profit benefits to the company. Qualitative consideration incorporates the analysis of product quality, flexibility of the project returns and operational control that evaluates the duration of cash flows, affect of inflation rate and market interest rates (Sangogboye, Droegehornand Porras2016). Further, technical consideration is an intangible factor used to review the manufacturing and service capacity of the proposed project. Accordingly, Rick’s recommendation would be affected by considering the technical feasibility of projection profile P90, P50 and P10. In addition, intangible consideration includes managerial consideration in terms of availability of sources, employees’ strength and involvement in connection with the manufacturing process with the proposed project (Gai and Steenkamp2014).

Intangible considerations incorporate feasibility with respect to project economy that determines the cost benefits in accordance with the current market scenarios. This consideration involves analysis and evaluation of projects as per market inflation rates, interest rates, foreign exchange rates and other regulatory principles. Acceptance or rejection a proposed project depends on the economic feasibility as several legal regulations affects the cash flows other than the fixed costs and variable costs of the proposed projects. In several projects it can be considered that the project generates positive net present value and shorter payback period but the economic feasibility can be critical or lower that would affect the overall profitability of the company (Dickinson 2014). Recommendation of Rick would also be affected with the social, cultural and political considerations in terms of supply of related sources, compliance of trading regulations and benefits to the society. Business organization is responsibleto address the social factors and corporate governance while operating proposed projects that provides transparent, accountable and reliable outcomes to the company as well as to the society (Rossi 2015).

Intangible Considerations that Might Affect Rick’s Recommendation

(Source: Created by author)

(Source: Created by author)

The above diagram reflects sensitivity of each production profile in terms of oil prices and natural gas prices for the products P90, P50 and P10. The diagram indicates the sensitivity in the middle region with respect to the year 2005 that reflects lower price of oil prices and gas prices in accordance with inflation rate as well as discount rate. It reflects sensitivity of the proposed project with respect to the total price of the projects, inflation rate and discount rate under option 1, 2 and 3 respectively. The diagram indicates the sensitivity with respect to the payback period in duration between 0.50- 1.00 between the three projects.

In view of the measurement of net present values and payback period for the proposed projects under three options, it can be suggested that the production profile P90 should not be accepted. Net present value of the production profile P90 reflected negative value together with the longer duration to recover the investment amount of the project, which is not feasible for the organizational profitability. In addition, the internal rate of return and modified rate of return of P90 is also lower, which denotes the lower value of expected cash inflows from the project hence, it should not be accepted. Production profile P50 reflects positive net present value together with the shorter payback period under all the three options. NPV under option 3 is the lowest amounted to $111 million with payback period 1.74 while the same was $253 million with payback period 1.42 under option 1. On the other hand, net present value for P10 under option 1 has been $442 million with the payback period 1.30 but the internal rate of return in the third option was highest with 32.55%. Besides, outcome under the second option reflects considerably longer payback period and lower NPV than that under option 1. As the tangible factors of the proposed production profile is lower in P50, it is suggested to consider the project P10 option 1 since it produces highest NPV as well as shortest payback duration.

Reference List

Dickinson, J.R., 2014. The feasibility of the balanced scorecard for business games. Developments in business simulation and experiential learning, 30.

Gai, K. and Steenkamp, A., 2014. A feasibility study of Platform-as-a-Service using cloud computing for a global service organization. Journal of Information System Applied Research, 7, pp.28-42.

Galvez, E.A., Ordieres-Meré, J. and Capuz-Rizo, S.F., 2015.Analysis of project duration uncertainty using global sensitivity analysis. The Journal of Modern Project Management, 2(3).

Gorshkov, A.S., Rymkevich, P.P., Nemova, D.V. and Vatin, N.I., 2014. Method of calculating the payback period of investment for renovation of building facades. Stroitel’stvoUnikal’nyhZdanij i Sooruzenij, (2), p.82.

Lee, I. and Lee, K., 2015. The Internet of Things (IoT): Applications, investments, and challenges for enterprises. Business Horizons, 58(4), pp.431-440.

Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.

Sánchez, M.A., 2015. Integrating sustainability issues into project management. Journal of Cleaner Production, 96, pp.319-330.

Sangogboye, F.C., Droegehorn, O. and Porras, J., 2016. Analyzing the Payback Time of Investments in Building Automation.In Sustainable Ecological Engineering Design (pp. 367-381).Springer International Publishing.