Guest post –George Aubrey – Petroleum Engineer and President of Trailblazer Energy
The players in the SCOOP and STACK plays are touting internal rates of return (IRR) in the 50% to 80% range. What does this really mean AND would a 5% change in the Oklahoma severance tax rate (2% to 7%) make a significant change in the operators decision to drill wells?
This is a basic business school discussion… for projects being evaluated independently (i.e. drill in SCOOP or STACK, or any other project of any kind) the cash flows from new projects must include the effects the the new projects have on existing projects. The simple concept compels financial managers to go back and reevaluate existing projects and helps managers focus on the relevant cash flows attributable to a new project.
IRR and net present value (NPV) are kissing cousins. What the players in the slide deck are saying is that they have made a decision to invest in these areas because their return is very swift and is better than anywhere else, otherwise why invest. Clearly the wells being drilled are fantastic.
So we now need to apply a little common sense. Would an operator decide to exit a play where the return took a 5% hit, assuming a severance tax resulted in a true 5% reduction in IRR (it wouldn’t because of all of the other moving parts, stated above)?
Bluntly, hell no.
The range of IRRs in any one area of either the SCOOP or STACK play is greater than the impact of the 5% delta in severance tax across the board. Translation, they would still drill and wouldn’t blink an eye, even the one with the fake tear.
Most of the arguments against the tax are hollow. If an operator is drilling a very risky, costly and complex project and ends up with a 12% IRR, they have other issues. Assuming the public data in these slides is accurate, then returning to the 7% severance tax rate isn’t even a blip on their radar.