90 Case 14 Northern Gushers Northern Gushers Drilling has developed a lease on the North Slope of Alaska over the last five years. They have drilled 16 production wells evenly spaced over the four square miles of the lease tract. Every well’s production declines over time, so to maintain a “steady” total flow new wells are drilled. Specifically, total production from the existing wells will decline at 17% per year if no new wells are drilled. All wells have been directionally drilled from the gravel drill pad, which also contains a processing facility (see Figure 14-1). Figure 14-1 Field Arrangement Case 14 Northern Gushers 91 This processing facility separates water and natural gas from the crude oil stream. By reducing the pressure from formation to atmospheric levels, the volatile gases are removed from the oil. The oil is then dehydrated to remove water before transfer to the pipeline. As shown in the flowchart of Figure 14-2, a small portion of the natural gas is used to power the facility. Then most of the natural gas and all the water are repressurized and reinjected into the formation. This reinjection avoids the environmental problems of flaring the gas or surface disposal of contaminated water. It also helps maintain the pressure in the oil formation to increase total recovery. Figure 14-2 Processing Flow Chart The timing of new wells has been planned to maintain a steady flow of about 20,000 barrels of oil per day (BOPD). This flow rate is the “shipping space” on the Great Northern Pipeline that has been allotted to Northern Gushers parent company. Fluctuations in Cases in Engineering Economy 2nd by Peterson & Eschenbach 92 production are matched with the shipping space by buying, selling, and trading with other shippers at about the tariff’s cost per barrel. A second consideration has been maximizing total recovery by distributing new wells over the leased tract. Thus, each of the 16 wells has helped maintain current production and also increased total recovery from the field. Now Northern Gusher is facing a different problem. The entire leased tract has been covered by the 16 wells. New wells will be drilled “in-between” existing wells and will therefore have less impact on total recovery from the field. Each new well will increase production now by 2000 BOPD and increase the decline rate by 1%. Since each well costs about $2 million to drill and $1.75 million to tie into the production facilities, the management of Northern Gushers must justify this decision to their parent company by identifying the rate of return on the required capital investment. Additional capital is required every 7 years to do a well work-over for $1.25 million. Abandonment costs in the final year of production amount to 10% of the initial drilling and facility costs. The abandonment costs are required by state agencies to return the land to its initial condition. Cu ...

1. 90
Case 14
Northern Gushers
Northern Gushers Drilling has developed a lease on the North
Slope of Alaska over the last
five years. They have drilled 16 production wells evenly spaced
over the four square miles of
the lease tract. Every well’s production declines over time, so to
maintain a “steady” total
flow new wells are drilled. Specifically, total production from
the existing wells will decline
at 17% per year if no new wells are drilled. All wells have been
directionally drilled from the
gravel drill pad, which also contains a processing facility (see
Figure 14-1).
Figure 14-1 Field Arrangement

2. Case 14 Northern Gushers
91
This processing facility separates water and natural gas from the
crude oil stream. By
reducing the pressure from formation to atmospheric levels, the
volatile gases are removed
from the oil. The oil is then dehydrated to remove water before
transfer to the pipeline. As
shown in the flowchart of Figure 14-2, a small portion of the
natural gas is used to power the
facility. Then most of the natural gas and all the water are
repressurized and reinjected into
the formation. This reinjection avoids the environmental
problems of flaring the gas or
surface disposal of contaminated water. It also helps maintain
the pressure in the oil
formation to increase total recovery.
Figure 14-2 Processing Flow Chart
The timing of new wells has been planned to maintain a steady
flow of about 20,000
barrels of oil per day (BOPD). This flow rate is the “shipping
space” on the Great Northern
Pipeline that has been allotted to Northern Gushers parent
company. Fluctuations in
Cases in Engineering Economy 2nd by Peterson & Eschenbach

3. 92
production are matched with the shipping space by buying,
selling, and trading with other
shippers at about the tariff’s cost per barrel. A second
consideration has been maximizing
total recovery by distributing new wells over the leased tract.
Thus, each of the 16 wells has
helped maintain current production and also increased total
recovery from the field.
Now Northern Gusher is facing a different problem. The entire
leased tract has been
covered by the 16 wells. New wells will be drilled “in-between”
existing wells and will
therefore have less impact on total recovery from the field. Each
new well will increase
production now by 2000 BOPD and increase the decline rate by
1%. Since each well costs
about $2 million to drill and $1.75 million to tie into the
production facilities, the
management of Northern Gushers must justify this decision to
their parent company by
identifying the rate of return on the required capital investment.
Additional capital is required
every 7 years to do a well work-over for $1.25 million.
Abandonment costs in the final year
of production amount to 10% of the initial drilling and facility
costs. The abandonment costs
are required by state agencies to return the land to its initial
condition.
Currently, the tariff for transportation through the pipeline is
$5.25 per barrel, and

4. another $3.75 per barrel is required to ship it to market. The
incremental annual operating and
maintenance cost for the field is $200,000 for each new well.
At this point, Northern Gusher must decide whether to initiate
planning and construction
for Well 17. This particular well could come on line next year
with an estimated production
rate of 2000 BOPD once tied into existing separation facilities.
By next year, Northern
Gusher’s total production rate will fall to 18,000 BOPD. The
production of the 16 wells is
declining at 17% per year. With the new well added in, the
higher production rate results in a
field decline rate that is 1% higher at 18% per year.
For simplification, the new decline rate can be assumed to begin
as soon as the new well
is drilled since the field will be producing at a higher rate
almost from the start. While more
wells will be drilled in the future, economic analysis of Well 17
is done without considering
them. Oil production at the facility will be closed down (the
field will be shut-in) when the
total field production reaches 500 BOPD. At that production
rate, it is no longer economic to
operate the field.
Because some of the oil produced by Well 17 would have been
produced in later years by
nearby wells, the incremental “production rate” with Well 17
versus without Well 17 will be
negative in later years. This sign change in the cash flows can
result in multiple rates of
return, so that is an additional concern of management.

5. The value of oil has varied dramatically over the last six years,
from a low of $18 per
barrel to a high of $140 per barrel, back down to $22 per barrel
and then back up to the
Case 14 Northern Gushers
93
current level of $45 per barrel. Because of this vast uncertainty,
your boss has given you
guidelines of $30 per barrel and a horizon of 20 years for the
initial analysis.
Should Well 17 be added now, and how much additional oil will
be produced? What is
the incremental rate of return on this investment?
Options
1. If management demands an internal rate of return of 15% on
investments, can Well
17 be justified now or at a later date? If now, when can well 18,
19, and so on be
justified? Each of these later wells will have a similar effect on
the total decline rate
for the field. Specifically, assume that each well increases the
decline rate by 1%.
2. Rather than considering the price of oil to be “fixed” at its
current level, consider the

6. impact of a higher or lower inflation rate for oil than for the
economy as a whole.
96
Case 16
Great White Hall
Flatland Views has advertised for proposals to build a new
community center, but the city
council cannot agree on how to evaluate the submitted
proposals. The request for proposal
(RFP) specified that respondents had to meet certain basic
needs, although optional items
could be included. The RFP also asked that each respondent
calculate a benefit/cost (B/C)
ratio using a discount rate of 12%. The RFP did specify the
approximate size of each optional
facility and the use that could be expected (and the value of
such use in dollars per hour).
The RFP stipulated that the council would select a package of
facilities based on
estimated construction costs and B/C ratios. Since this package
might not match any

7. proposal, the council could issue a new RFP. However, if a new
RFP is issued, only
respondents to the first RFP may respond. The council’s intent
is to provide an incentive for
participation in the first RFP. Instead of a second RFP, the
council could choose to simply
negotiate with one of the original bidders.
Three firms responded to the RFP, but they used different
assumptions on how to
calculate the ratio as well as including different options within
their proposals. Their
construction materials and associated lives are similar, but their
designs differ substantially.
The proposals can be summarized as follows.
Tightfisted Proposal
Averell Johnson, the conservative patriarch of the city’s
construction community, has
proposed a bare-bones facility (see Table 16-1). Assuming 50
years of use and end-of-period
Case 16 Great White Hall
97
cash flows, his proposal has a B/C ratio of __.1 His proposal
also assumes that construction
expenditures are all made at the start of the construction period.
Table 16-1 Tightfisted Proposal

8. Construction: 1 year: $2.5 million
Annual operation: Gym: $120,000
City offices: $190,000
Annual benefit: Gym: 60 hours/week at $200/hour
Major Projects Proposal
The proposal that has been supported by the “town and gown”
crowd includes a small
auditorium/theater and a library as well as the gym (see Table
16-2). Major Projects Inc. has
evaluated the proposal over 30 years of use for the benefits and
for a 12-month term for the
construction phase. Major Projects has assumed end-of-period
cash flows, but they have
analyzed the construction phase as 12 months—each with an
equal share of the construction
expenditures. Their calculated B/C ratio is ___.1
Table 16-2 Major Projects Proposal
Construction: 12 months: $4.8 million
Annual operation: Gym: $110,000
City offices: $165,000
Library: $450,000 (mostly salaries)
Theater: $65,000
Annual benefit: Gym: 60 hours/week at $200/hour
Library: $0.5 million in improved education
Theater: 16 hours/week at $450/hour

9. 1 The omitted B/C ratios for each facility are not necessary for
the rest of the case. The “easiest” option
is to calculate them.
Cases in Engineering Economy 2nd by Peterson & Eschenbach
98
Energy Breakthrough Proposal
The third proposal (Table 16-3) is from a new firm that
specializes in the design and
construction of energy-efficient structures. They based their
B/C ratio, _____, on assumptions
of 40 years of use and costs and benefits that flow continuously
over that time (distributed
rather than end-of-period cash flows).
Table 16-3 Energy Breakthrough Proposal
Construction: 1 year: $3.9 million
Annual operation: Gym: $ 65,000
City offices: $100,000
Theater: $15,000
Annual benefit: Gym: 60 hours/week at $200/hour
Theater: 16 hours/week at $450/hour
The Council’s

10. Solution
Overwhelmed by the responses, the city council has decided to
hire you as a consultant. Your
contract requires you to calculate comparable ratios, to
recommend a package of facilities,
and to recommend a contractor.
Options
1. The problem can be simplified by specifying that all projects
assume end-of-period
cash flows except for construction costs, which could be
specified to occur before
construction begins. This may or may not be the best
assumption.
2. The problem can be simplified by limiting it to the
calculation of the omitted B/C

11. ratios.
3. The problem can be simplified by reducing the scope of the
consultant’s contract to
constructing valid comparisons of the three proposals.