Bridging Valuation Gaps: Part 1

Bakken Shale Bankruptcy Valuation Issues

Due to a precipitous drop in oil prices since June 2014, oil exploration and production companies in the U.S. have struggled to pay their debts and in many cases have had to file for bankruptcy. This is the first post in a three part series 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. Whether companies are looking to sell these reserves to improve their cash balance, or are trying to generate reorganization cash flow projections during a Chapter 11 restructuring, understanding how to value PUDs and unproven reserves is crucial to survival in a down market.

This first post looks at the traditional DCF valuation method and market approach method and how they underestimate value in down markets. The subsequent two sections will focus on one potential method to use in place of the DCF, the option pricing method, and will explore both its advantages in down markets and the dangers of adopting option pricing models for oil and gas.

The Problem: Traditional Valuation in Distressed Markets

The petroleum industry was one of the first major industries to widely adopt the discounted cash flow (DCF) method to value assets and projects—particularly oil and gas reserves. These techniques are generally accepted and understood in oil and gas circles to provide reasonable and accurate appraisals of hydrocarbon reserves. When market, operational, or geological uncertainties become challenging, such as in today’s low price environment, the DCF can break down in light of marketplace realities and “gaps” in perceived values can appear.

While DCF techniques are generally reliable for proven developed reserves (PDPs), they do not always capture the uncertainties and opportunities associated with the proven undeveloped reserves (PUDs) and particularly are not representative of the less certain upside of possible and probable (P2 & P3) categories. The DCF’s use of present value mathematics deters investment at low ends of pricing cycles. The reality of the marketplace, however, is often not so clear; sometimes it can be downright murky.

In the past, sophisticated acquirers accounted for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC) or applying a judgmental reserve adjustments factor (RAF) to downward adjust reserves for risk. These techniques effectively increased the otherwise negative DCF value for an asset or project’s upside associated with the PUDs and unproven reserves.

At times, market conditions can require buyers and sellers to reconsider methods used to evaluate and price an asset differently than in the past. In our opinion, such a time currently exists in the pricing cycle of oil reserves, in particular to PUDs and unproven reserves. In light of oil’s low price environment, coupled with the forecasted future price deck, many, if not most, PUDs appear to have a negative DCF value.

Some non-core asset transactions in today’s market seem to concur with this assessed zero value for all categories of unproven reserves and PUDs. An example of this is Samson Oil and Gas’s recent purchase of 41 net producing wells in the Williston Basin in North Dakota and Montana. The properties produce approximately 720 BOEPD, and contain estimated reserves of 9.5 million barrels of oil equivalent. Samson paid $16.5 million for the properties in early January 2016 and estimates that within five years they can fund the drilling of PUDs. Samson’s adjusted reserve report, using market commodity prices at the time of the transaction, indicated PDP reserves worth $15.5 million, PDNPs worth $1 million, and PUDs worth $35 million—a total of $52 million in reserves present valued at 10%. This breakdown indicates dollar for dollar value was given on the PDP and PDNP reserves, but zero cash value given on the PUDs.

  • Significant decline and volatility in oil prices from (1) uncertain future demand and (2) current excess supply
  • Debt level pressures with (1) loan covenant requirements and (2) cash flow requirements
  • A low deal volume environment as market participants have been in a “wait and see” stance since oil prices began declining over twelve months ago.

Essentially there are few buyers in the current market place and many sellers desperate for cash. Since those sellers need cash quickly to sustain their business, they have to lower their asking prices to levels that will continuously attract bidders. The gap between an asset’s sale value and what it is worth to the new asset holder widens considerably.

What does this mean for the E&P companies looking to reorganize under a Chapter 11 Bankruptcy? There are five key concepts for management teams and their advisors to be familiar with to understand how reserve valuation impacts Chapter 11 reorganization.

  1. Liquidation vs. Reorganization. The proposed reorganization plan must establish a “reorganization value” that provides superior outcomes for shareholders relative to a Chapter 7 liquidation proceeding.
  2. Liquidation Value. This premise of value assumes the sale of all of the company’s assets within a short period of time. Different types of assets might be assigned different levels of discounts (or haircuts) based upon their ease of disposa
  3. Reorganization Value. As noted in ASC 852, Reorganizations, reorganization value “generally approximates the fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring.” Reorganization values are typically based on discounted cash flow (DCF) analyses.
  4. Cash-Flow Test. A cash-flow test examines the viability of a reorganization plan, and should be performed in order to determine the solvency of future operations. In practice, this test involves projecting future payments to creditors and other cash flow requirements including investments in working capital and capital expenditures.
  5. Fresh-Start Accounting. Upon emergence from bankruptcy, fresh-start accounting may be required to allocate a portion of the reorganization value to specific identifiable intangible assets such as tradename, technology, or customer relationships. Fair value measurement of these assets typically requires use of the multi-period excess earnings method or other techniques often used in purchase price allocations following a business combination.

If recent market transactions are utilized to establish a liquidation value, then it stands to reason that very little, if any, value will be given to the PUD reserves. For a company trying to avoid liquidation in a distressed market where sale prices do not indicate true value, there may still be a way to show significant value if reserves are retained in reorganization. However, that reorganization value has typically been based on a DCF. It is possible that the DCF may capture significant value in PUD reserves, because in reorganization debt levels are adjusted. When debt levels are adjusted the cash flow PUD reserves need to generate to be viable is much lower. This will provide two significant benefits: more time and possibly more cash. More time may allow the global oil and gas prices to increase while the additional cash flow from lower interest payments may allow investment in future PUD wells.

Unfortunately, it is still the case that the present value calculation is strongly tied to current market conditions, and thus even for companies with reasonable leverage, many PUD and unproven reserves show negative cash flow. The presence of some sizable transactions made without significant PDPs shows that there are buyers who disagree with this assessment and see value in these reserves. The issue is demonstrating that value in either a sale or bankruptcy negotiation. An option pricing model is one solution that more accurately accounts for the value of the increased time provided by restructuring the debt. In the next two posts we will look at times when option pricing may be a better model, and examine its potential issues. For a more detailed explanation of bankruptcy, DCF methods, or option pricing, please contact one of our valuation experts.