The Fair Market Value of Oil and Gas Reserves

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.¹

The American Society of Appraisers recognizes three general approaches to valuation: (1) The Cost Approach, (2) The Income Approach, and (3) The Market Approach.  The IRS provides guidance in determining the fair market value of an oil and gas producing property.  Treasury Reg. 1.611–2(d) offers that if possible the cost approach or comparative sale approach should be used before a discounted cash flow analysis (DCF).  When valuing acreage rights comparable transactions do provide the best indication of value.  However, when valuing reserves, a DCF is often the best way to allocate value to different reserve categories because comparable transactions are very rare as the details needed to compare these specific characteristics of reserves are rarely disclosed.

Cost Approach

The cost approach determines a value indication of an asset by considering the cost to replicate the existing operations of an asset. The cost approach is used when reserves have not been proved up and there have been no historical transactions, yet a participant has spent significant time, talents, and investments into exploratory data on an oil and gas prospect project.

Market Approach

The market approach is a general way of determining a value indication of an asset by using one or more methods that compare the subject to similar assets that have been sold.

Because reserve values vary between oil and gas plays and even within a single play, finding comparable transactions is difficult. A comparable sale must have occurred at a similar time due to the volatile nature of oil and gas prices.  A comparable sale should be for a property that is located within the same play and within a field of similar maturity.  Additionally, comparable transactions must be thoroughly analyzed to make sure that they were not transacted at a premium or discount due to external factors.  Thus the market approach is often difficult to perform because true comparable transactions are rare. However, the transaction method generally provides the best indication of fair market value for acreage and lease rights.

Income Approach

The income approach estimates a value indication of an asset by converting anticipated economic benefits into a present single amount.  Treasury Reg 1.611 – 2(e)(4) provides a straightforward outline of how the approach should be used.

In practice, this method requires that:

1. The appraiser project income, expense, and net income on an annual basis
2. Each year's net income is discounted for interest at the "going rate" to determine the present worth of the future income on an annual and total basis
3. The total present worth of future income is then discounted further, a percentage based on market conditions, to determine the fair market value. The costs of any expected additional equipment necessary to realize the profits are included in the annual expense, and the proceeds of any expected salvaged of equipment is included in the appropriate annual income.

Cash Inflows

In order to estimate revenue generated by an oil and gas reserve, we must have an estimate of production volume and price.  Estimates of production are collected from Reserve reports which are produced by geological engineers.

The forward price curve provides monthly price estimates for 84 months from the current date.  Generally, the price a producer receives varies with the price of benchmark crude such as WTI or Brent. Thus, it is important to carefully consider a producers contract with distributors. For example a company may sell raw crude to the distributor at 65% of Brent.

Cash Outflows

Many E&P companies do not own the land on which they produce. Instead they pay royalty payments to the land owner as a form of a lease payment.  Royalty payments are generally negotiated as a percentage of the gross or net revenues derived from the use of the property.  Besides royalty payments and daily operating costs, it is important to have conversations with management to understand future infrastructure maintenance and capital expenditures.

Discount

Oil and gas reserves can be based on pre-tax or after-tax cash flows.  Pre-tax cash flows make reserve values more comparable as tax rates vary by location.  When using pre-tax cash flows, we use a pre-tax cost of debt and pre-tax cost of equity to develop a WACC.

Risk Adjustment Factors

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 the Probable and Possible reserve categories.  A risk adjustment factor could be used to the discounted present value of cash flows according to the category of the reserves being valued to account for PUDs upside and uncertainty by reducing expected returns from an industry weighted average cost of capital (WACC).  You could also add a risk premium for each reserve category to adjust a baseline WACC, or keep the same WACC for all reserves but discount the present value of the cash flows accordingly with comparable discounts to those shown below.

End Note