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YJ Ltd YJ Ltd (YJ) is a UK company
which was listed on AIM in January 2007 with an initial public offering (IPO) of US$60 million. Its main shareholders are 12 large institutional shareholders which together own 96% of the shares. YJ had been formed two years earlier with the purpose of identifying potential oil and gas fields that could be brought into production. The principal activity of YJ is the exploration of, and production from oil and gas fields. The company's strategy is to explore, appraise and develop into production its licensed oil and gas fields both safely and responsibly. Value is created as YJ proceeds through the initial stages of exploration through to production.
A summary of YJ's current operations is shown on pages 8-9.
To date, YJ has been successful in identifying and bringing into production three oil and gas fields. This involved obtaining the required licences, test drilling and then proceeding through to production drilling at these three locations. It has therefore been successful in achieving its investors' expectations. However, the oil and gas exploration industry is hugely capital intensive before any oil or gas can be brought into production and sold. Therefore, equity funding alone was inadequate to fund YJ's plans. Following the identification of YJ's first two oil and gas fields in 2008, it secured loans totalling US$140 million to help to finance production drilling. These loans are repayable in 2018 and are at an interest rate of 11% per year. It was able to secure this funding after successful test drilling and obtaining licences, and obtaining an independent report on the proven oil and gas reserves at these two locations. YJ's bank also provides an overdraft facility of a maximum of US$5 million to help meet the peak demands in working capital. The overdraft interest rate is 12% per year. It is clear from the interest rates above that the lender of the loan funds and the bank providing the overdraft saw similar levels of risk (as the interest rates charged on the loans were similar). Overdrafts, being unsecured, are traditionally viewed as risky but here the loans were also viewed as carrying higher levels of risk. This is because of the lack of traditional assets upon which to secure the loans. The loan financier could be 6 said to be accepting higher than usual levels of risk in return for higher than usual returns in the form of interest. This is normal in this industry.
YJ's board YJ's board consists of a non-executive Chairman and five non-executive directors as well as six executive directors. A summary of YJ's board is shown in Appendix 1 on page 16. Oliver Penn is the founding Chief Executive Officer (CEO). He had always wanted to form an E&P company and to recruit a team of experts in their specialised areas who he could trust to share his vision of success. He was very pleased with YJ's success since YJ's formation in 2005. However, he suffered serious ill health and chose to retire in April 2014. Ullan Shah is the newly appointed CEO and started in June 2014. He has spent his first month since starting visiting all of YJ's operational oil and gas fields, and speaking to the geologists and survey teams on current potential oil and gas fields. At the first board meeting after Ullan Shah had been appointed, he informed his colleagues that he wants YJ to identify and bring new oil and gas fields into operation at a faster rate than currently achieved. Orit Mynde (Chief Financial Officer) was concerned that YJ did not currently have adequate funding in place for test and production drilling at new locations. This is because almost all of YJ's cash generated from operations was already being spent on current operational oil and gas fields as well as on surveying potential new oil and gas fields. Further new funding would be required for test and production drilling at any newly licensed oil and gas fields, depending on if, and when, YJ was to be granted further licences. YJ's shares and financials YJ has 10 million shares in issue, each of US$1 par value. Par value is the book value of each share it is rarely the market value. If shareholders pay more than the par value to a company to buy new shares then the excess is known as a share premium. The shares were offered at the IPO (Initial Public Offering) at US$6 per share. This comprised the nominal value of US$1 per share plus a share premium of US$5 per share. The company has an authorised share capital of 50 million shares. The company has not issued any further shares since its IPO in 2007. However, the new CEO, Ullan Shah, is planning to buy 200,000 shares on the market in 2014. To date, the board of YJ has not declared any dividends. The shares are held as follows: Number of shares held at 31 March 2014 Percentage shareholding Million Institutional shareholders 9.60 96.0 % Oliver Penn (now retired) 0.20 2.0 % Orit Mynde 0.05 0.5 % Milo Purdeen 0.10 1.0 % Jason Oldman 0.05 0.5 % Total 10.00 100 % 7 Even though YJ is listed in the UK, it prepares its accounts in US Dollars, as is usual in the oil and gas industry. All revenues from the sale of oil and gas are priced in US Dollars. Its operating expenses are incurred in a range of European, African and Asian currencies, and therefore it is exposed to the impact of currency fluctuations. Where possible, YJ uses a range of hedging techniques to minimise its currency exposure. No advice is sought on currency hedging as YJ is happy with its operations in this area. YJ's revenues grew by 47% to US$174 million in 2013/14 and the company reported record post-tax profits of US$41 million (2012/13 was US$20 million). The company has made operating losses in each year through to and including 2011/12 due to the high exploration costs that precede the revenue streams. Its first profitable year was the year ended 31 March 2013 and all of its previous tax losses resulted in no tax being payable for the 2012/13 financial year. The level of profits in the year ended 31 March 2014 were sufficiently high for the remaining tax losses to be used up, resulting in a small tax liability in the last financial year. Consequently any further profits will be fully taxable at 24%. An extract from YJ's accounts for the year ended 31 March 2014 is shown in Appendix 2 on page 18. YJ's cash flow statement for the year ended 31 March 2014 is shown in Appendix 3 on page 19. 8 Drilling for oil and gas All of the drilling operations that YJ undertakes are off-shore and in shallow water. YJ's geologists and survey teams are experts at studying and scanning potential areas for oil and gas reserves. YJ's team undertakes extensive survey work over potential oil and gas fields including 2D and 3D seismic surveys and controlled source electromagnetic mapping to try to establish the size and depth of possible oil and gas reserves, before licence applications and test drilling commences. The team has been extremely successful to date with only one failure (see below). Once a location has been identified and licences obtained, then an off-shore installation is set up. Oil and gas off-shore installations are industrial "towns" at sea, carrying the people and equipment required to access the oil and gas reserves hundreds or even thousands of metres below the seabed. YJ uses outsourced drilling teams and outsourced service personnel for these off-shore installations. YJ hires mobile drilling platforms and FPSOs as the cost of owning drilling platforms is too prohibitive. As such YJ only supervises the technical operations. Its expertise rests with its geology knowledge and its ability to control the outsourcers.
The cost of drilling each production shallow-water well can be in excess of US$30 million. Therefore, before oil and gas production can commence, it is necessary to undertake preliminary test drilling to confirm exactly where the oil or gas reserves are and the size of the reserves. After test drilling has been undertaken, the most effective way to extract the oil and gas and bring them to the surface is established. Oil and gas fields are classified according to the reasons for drilling and the type of well that is established. The classifications are: "Test" or "Exploration wells". Defined as wells which are drilled purely for information gathering purposes in a new area. Their function is to establish whether survey information has accurately identified a potential new oil and gas reserve. Test wells are also used to assess the characteristics of a proven oil or gas reserve, in order to establish how best to bring the oil and gas into production. "Production wells". Defined as wells which are drilled primarily for the production of oil or gas. These are drilled after the oil or gas reserve has been assessed, the size of the oil or gas reserve has been proved, and the safest and most effective method for getting the oil or gas to the surface has been determined.
YJ's current operations YJ currently has three oil and gas fields in production. These three oil and gas fields are relatively small compared to some of the larger oil and gas fields operated by the multi-national oil companies. All three oil and gas fields are located off-shore with shallow-water drilling wells. One of YJ's oil and gas fields is located off-shore around Africa, field AAA. Two are located off-shore around Asia, fields BBB and CCC. These three oil and gas fields were identified and surveyed in the company's first few years of operation. AAA and BBB have been in production since 2011. CCC was brought into production in early April 2013. YJ has PSA licences from each of the respective governments for these three oil and gas fields whereby the governments receive a share of the profits after royalties and production costs. The royalty and licence costs are included in the cost of sales in the Profit or Loss Statement. 9 YJ's three current oil and gas fields have been independently checked to verify their proven commercial reserves. These proven commercial oil and gas reserves total: Oil: 9.198 mmbbl (mmbbl is defined as "millions of barrels of oil"). Gas: 12.780 mmbble (mmbble is defined as "millions of barrels of oil equivalent"). These reserves exclude "contingent resources" of oil and gas. Contingent resources are defined as oil and gas reserves which are not commercially feasible to extract using current technology. Details of the production of oil and gas from these three oil and gas fields for the last two financial years are shown in Appendix 4 on page 20. YJ's geologists and survey teams are currently investigating 12 further potential oil and gas fields. This includes four oil and gas fields in Asia and Africa for which YJ has applied for licences to test drill. The outcome of the application for these four licences should be known over the next six months. Milo Purdeen (Director of Exploration) and Jason Oldman (Director of Legal Affairs) have worked closely to meet all of the requirements of the licence applications for the four identified potential oil and gas fields. However, they both find dealing with some members of the government of the African and Asian countries, which own the on-shore and off-shore land, difficult and at times ethically challenging. Some of these Asian and African government officials have requested payment of fees, which Jason Oldman considers to be bribes. He has clearly stated that this is not how YJ conducts business and took a clear ethical stance with the support of Oliver Penn. The remaining eight potential oil and gas fields, in Asia and Africa, are at earlier stages of survey work and exploration. Since YJ was listed on AIM in 2007, it has applied for a total of eight licences for test drilling, including the four it is awaiting to hear whether it will be given a licence for. Only one potential oil and gas field, DDD, was established to be far smaller than had been originally estimated and was not considered economic to take into production. The total cost of test drilling for the oil and gas field, DDD, which was not taken into production, was written off in the Profit or Loss Statement in 2011/12. This write-off cost was US$15 million. YJ's geologists and survey team have since become even more careful when identifying potential new oil and gas fields following this write-off. However, the fact that only one of YJ's potential oil and gas fields did not go into production is considered to be an acceptable risk, as some competitors incur a higher proportion of write-offs to the number of oil and gas fields that enter production. YJ outsources all of its drilling work to specialised companies. At the end of March 2014, it employed fewer than 200 employees. Of these employees, around half of them work on the exploration of potential new oil and gas fields. Of the remaining employees of YJ, there is a small specialised team which works on licence applications and the rest are involved with the management and supervision of operations at YJ's three current operational oil and gas fields.
Accounting for revenues and costs The financial accounting principles in the oil and gas industry are complex and the basic principles are outlined below. No investigation into financial accounting principles is required. Revenues are accounted for at the point of sale which is at the same time as the legal transfer of ownership. This typically occurs when the contracted volumes of oil and gas are delivered to the port in the country agreed in the contract of sale. YJ is generally responsible for the transportation of the oil and gas from the oil or gas fields to the entry port in the agreed country. This is usually a port close to the respective oil and gas fields.
YJ's customers are then responsible for the onward transportation, or storage of the gas or oil, from the agreed port. LNG is often stored in huge LNG storage tanks that are located near to several ports before onwards transportation. YJ sells its oil and gas: at the spot price on the open market to a range of buyers or on a commodity exchange, where oil and gas is sold in the form of a derivative, which is a promise to deliver a certain amount of oil or gas on a certain date at a specified place for a certain price. YJ can always sell its oil and gas, and it is usually sold before the oil and gas is shipped ashore.
The cost of oil and gas production is charged to the Profit or Loss Statement to match the volumes sold. Cost of sales includes the operating costs associated with operating wells from which oil and gas are being extracted (after drilling has been completed). These oil and gas production costs include royalties, PSA licence costs, the costs of delivering oil and gas to the ports at which the customers take delivery, as well as the amortisation of test and production drilling costs. 11 Administrative expenses include health, safety and environmental management costs, and are charged to the Profit or Loss Statement on an accruals basis relating to the time period to which they relate. Accounting for oil and gas exploration costs.
The accounting method used by YJ to account for oil and gas exploration costs is to capitalise all costs of exploration that lead to the successful generation of oil and gas fields. The GAAP accounting concept is that the oil and gas exploration costs are assets that are to be charged against revenues in the Profit or Loss Statement as the assets, i.e. the oil and gas fields are used. The oil and gas fields are treated in the Statement of Financial Position as long-term assets. This is because, like other capital equipment, the oil and gas reserves are considered to be long-term productive assets. All of the drilling and exploration costs associated with oil and gas fields that are unsuccessful and will not go into production are written off in their entirety. This includes any costs previously capitalised at the point that the oil and gas field is determined not to be productive. YJ has capitalised the costs of the drilling of all its wells within its three operational oil and gas fields and this is written off against revenues each year. The net book value of capitalised drilling and explorations costs, together with a small amount of other noncurrent assets, was US$189 million at the end of March 2014. IT systems When YJ was established in 2005 it implemented a range of IT systems using licensed off-the-shelf IT packages. Where possible the industry leading software package was selected. The IT systems are fully integrated and enable the production of executive summary reports as well as the ability to drill down to gain specific data on each entry or event. The IT systems that YJ operates are: A multi-currency nominal ledger, with integrated sales and purchase ledgers. Each entry identifies the project and the designated areas within each of the oil and gas fields. Therefore, costs can be identified by cost type, and also by each area within a survey area, test drilling location or an operational oil and gas field. A fixed assets register. Survey and scanning software packages, enabling the geologists to share data and build up 3D images for each area within a potential oil and gas field. Health, safety and environmental (HSE) IT systems to monitor and report on all HSE preventative actions taken and all actual incidents that occur. These systems enable all of YJ's managers to extract reports on risk management and preventative actions that have been taken, or are planned for the future. Production of Environmental Impact Statements for each location that YJ is operating in, including potential oil and gas fields, as well as all test drilling locations and the three oil and gas fields that are currently in production. 12 Health, Safety and Environmental issues Health, Safety and Environmental (HSE) issues are firmly placed at the top of YJ's objectives. YJ wishes to ensure that it actively prepares for and manages the risks it faces in the hostile and difficult environments in which it operates. Lee Wang, Director of Health, Safety and Environment, considers that accident prevention is a key factor in the oil and gas industry, as the results of even a minor accident can be significant or even catastrophic. Undertaking survey and test drilling in unknown areas, particularly off-shore drilling, carries risks. All of YJ's survey and drilling work undertaken in the last seven years has been completed without any major HSE incidents. Lee Wang endeavours to maintain high standards of HSE in YJ and this has been achieved in the following ways: Strong leadership and clearly defined responsibilities and accountabilities for HSE throughout YJ and its outsourced suppliers. Appointment of competent employees to manage activities. Developing specific HSE plans for each potential oil and gas field depending on the local and environmental conditions. Selecting, appointing and effectively managing competent outsourced contractors. Preparing and testing response plans to ensure that any incident can be quickly and efficiently controlled, reported on and actions taken to ensure that it does not re-occur.
Continuous improvement of HSE performance by monitoring, reporting and on-site audits. Regular management reviews of YJ's HSE IT systems to ensure that its IT systems meet or exceed international standards. Following some international terrorist incidents in early 2013, Lee Wang persuaded the board to appoint an international security company. This security company provides trained personnel to improve the security at all of YJ's test drilling and production drilling locations and has done so since April 2013. This security company also escorts all of YJ's employees and outsourced personnel whilst they are travelling to, and from, all of YJ's drilling sites.
Questions in case study.
1. Identify the issues the company is facing?
2. What is the current practice of the company?
3. What will be the future state where company want to achieve?
4. Who has more influence than other stakeholder?