At Mercer Capital we recognize that the low price environment is forcing many E&P companies either to sell reserves to improve their cash balance, or to reorganize through Chapter 11 restructuring. This is the third and final post in a series aimed at helping E&P companies to navigate the sale of non-core assets and bankruptcy by examining how option pricing, a sophisticated valuation technique, can be used to understand the future potential of the assets most affected by low prices, PUDs and unproven reserves. In past posts we discussed the difficulties of valuing PUDs and unproved reserves in low-price markets, and when option pricing can provide a more accurate valuation. In this third and final post we want to delve into the specifics of adapting option pricing from shares of stock to oil and gas, highlighting some of the challenges and key steps of the process.
Pitfalls and Fine Print
Option pricing, most often used in valuing stock options, can incorporate factors overlooked by a traditional DCF and enable a company to show to potential buyers or stakeholders the value of PUDs and unproved reserves even in low-price environments. There are, however, key differences in PUD optionality and stock options that create limitations to the model and can make it challenging to implement. Below are some areas where keen, rigorous analysis can be critical:
- Observable Market. The DCF is typically the best estimate of reserve value, followed by the market approach. This relationship flips when crude prices fall. Market participants understand that prices will eventually recover while it is more difficult to show this expectation using a terminal value for the DCF because the precise date of market recovery is unknown. However, today the prices have fallen so far for so long that the market approach is no longer accurate either. The oil and gas market is operating like a department store having a going out of business sale. In these moments an option pricing method is particularly useful, as it can more fully account for the volatility of oil and gas prices—which have both year to year supply and demand changes and significant seasonal swings.
- Risk Quantification. We have found that oil and gas price volatility benchmarks (such as long term index volatilities) are not all-encompassing risk proxies when valuing specific oil and gas assets. If not analyzed carefully, the model can struggle to capture some critical production profile and geologic risks that could affect future cash flow streams considerably. Risks include production profile assumptions; acreage spacing; localized pricing versus a benchmark (such as Henry Hub or West Texas Intermediate Crude); and statistical “tail risk” in the assumed distribution of price movements.
- Sensitivity to Capital Expenditure Assumptions. Analysis of an asset or a project’s cash flows can be particularly sensitive to assumed capital expenditure costs. In assessing capital expenditure’s role as both a cash flow input and an option model input, estimations of future costs can be very challenging, but are an important assumption to measure properly as they drive much of the calculated value.
- Drilling Resource Availability and Service Costs. When oil and gas prices fall, the availability of drilling resources tends to rise while the costs of drilling and oilfield services often fall precipitousl These factors can create an oscillating delta in both cost and timing uncertainties as the marketplace responds by investing capital into underdeveloped reserves while the fuse burns on existing lease rights.
- Time to Expiration. This input can require granular analysis of field production life estimates coupled with expiring acreage rights, and then adjusted for the drilling plans of an operator. The resulting time-weighted estimate can present problems with assumption certainty. The time value of an option can increase significantly if the mineral rights are owned; unconventional resource play reserves are included; there are foreign reserves; or the reserves are held by production. In these instances, the PUD and unproved reserve option to drill can be deferred over many years, making the option more valuable by increasing the chance of market fluctuations that will make the reserves profitable.
Utilization of modified option theory is not in the conventional vocabulary of many oil patch dealmakers, but the concept is considered among E&P executives as well during transactions in non-distressed markets. This application of option modeling becomes most relevant near the bottom of historic cycles for a commodity. If the right to drill can be postponed for an extended period of time, (i.e. five to ten years), the time value of the out-of-the-money drilling opportunities can have significant worth in the marketplace.
We caution, however, that there are limitations in the model’s effectiveness. Specific and careful applications of assumptions are needed, and even then Black Sholes’ inputs do not always capture some of the inherent risks that must be considered in proper valuation efforts. Nevertheless, option pricing can be a valuable tool if wielded with knowledge, skill, and good information, providing an additional lens to peer into a sometimes murky marketplace. Today’s marketplace is particularly murky, and an accurate appraisal is extremely valuable since establishing reasonable and supportable evidence for PUD, probable, and possible reserve values may assist in a reorganization process that determines the survival of a company. Given these conditions we feel that the benefits of using option pricing far outweigh its challenges.
Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.