Oil and Gas industry differs from other industries as to how it is valued financially; relying on factors which are subject to changes frequently. To figure the commercial value of an enterprise/company engaged in Oil & Gas sector apart from income, asset and market approach, a careful research of exploration, production as well as the current price of natural resources needs to be undertaken. These companies are valued at an industry specific metric as the investment in Oil and Gas is mainly commodity play. Hence, market prices are correlated to the expected price of the commodity they sell. Different methods of evaluation suit unique situation thus, aligning with the current market data. In this article, we will be discussing in brief about methods available for Fair Market Value ("FMV") determination to set a purchase price and determine the best investment in the ever changing landscape of energy sector.
2. Methods for determining Fair Market Value
There are various methods like comparable sales, rule-of-thumb, income forecast, replacement cost, known to be used by energy experts in order to determine an ideal range of the Fair Market Value for the purchaser or any stakeholder who is either intending to make an investment or contesting a claim in the Tribunal for any damages incurred in its due course. In this article, particularly the Discounted Cash Flow (DCF) method as in addition to all foreseeable business uncertainties and risks including technological (i.e. the possibility that the reserves might be recovered in the amounts or at the rates forecast), economic (like future oil and gas prices, market conditions, future operating costs and the potential need for additional capital expenditures), and political uncertainties (includes oil-import quotas, taxation, environmental considerations, etc) id discussed. The methods for estimating the FMV should consider the time value of money and the rate at which the investment amount is repaid.
- Comparable Sales Method: relies on the use of a recent sales price for the subject or a comparable property. With this technique, prices on real property are based on the previous sale price of that or a similar property. It is not frequently used within the industry/sector as rarely does the owner of a producing property admits that there is another as good as the ones he owns; therefore cannot possible be a comparable sale that has as much proved reserve or as much undeveloped potential as the one being offered for purchase.
- Rule-of Thumb Methods: There are several rule-of-thumb approaches that has some merits but in this industry, the method do not consider the length of time during which revenues will result from the investment and hence, does not takes into account the time value of money. Living by its flaws, the rule-of-thumb ratios, by ignoring time and other important investment considerations, should not be used except in conjunction with yardsticks that consider the annual rates at which revenues resulting from the investment will be received. The four most familiar rule-of-thumb methods are price paid per equivalent barrel of reserves, price paid per equivalent per day of production rate, profit-to-investment ratio, and the current income rate for a specified period of time.
- Replacement Method: The replacement cost method for determining the FMV has little application in determining the value of producing properties because of the difficulty in estimating the costs for finding replacement reserves. The method is known to lay its genesis from the "real-estate industry". Except in rare occasions, the value for an undeveloped wildcat acreage is seldom based on the volume of oil and gas that may be found.
- Income Forecast Methods: The methods using income forecasts are often called "cash-flow" methods and are very useful because they enable the investor to compare petroleum investments with other investments options using universal investment criteria. They seek to determine the amount an investor would be willing to pay for the right to receive the future income that the property is expected to yield. The income forecast methods analyze the time pattern of future income; thus they require that a forecast of expected revenue from the property be made, by time period, for the life of the property. To prepare the future net revenue (FNR) and the discounted future net revenue (DFNR) forecast, frequently called the present worth (PW) calculations, the engineer must estimate the hydrocarbon reserves for the property and must forecast the annual rates at which the reserves will be produced. After the most likely rates of production for the projected reserves have been prepared, economic considerations for the evaluation must be developed. These include consideration for any payment obligations, capital requirements, estimated operating costs and taxes, and costs for well repairs or development during the life of the property.
Out of all the methods discussed above, Income forecast methods are by far known to be the most widely accepted and sophisticated method of projecting or estimating the cash flows from the reserves bearing properties.
- Issues to be consider while
applying the DCF method of valuations in Oil and Gas
There are various issues that need to be considered while applying the Discounted Cash Flow method for determination of purchase prices in Oil and Gas enterprises. The experts, while determining the factors to be used in the method, should take due care of the susceptibility of the dynamism involved in the sector by being conscious of certain ingredients that forms the basis of such method.
Therefore, in order to inform its audience or the interested groups, an expert should be posed with the following questions for giving an informed choice to the acquirer or the purchaser under different market conditions or scenarios.
- Sensitivity Analysis
The sector is known to be extensively determined by the government policies and international dynamics with changing crude oil prices, foreign exchange fluctuations, geo-political risks to name a few. Hence, it becomes the duty of the expert to determine whether while applying the DCF model for projecting the future probable cash flows, he has provided "Sensitivity Analysis" which would inform the purchaser/acquirer of how price changes under lower/higher values of the parameters whose small variations can imply significant changes in quantum.
- Discount Rate
"As it was generally held that investments in oil enterprises were less risky than average investments in the market, the discount rate was reduced1 ", observed by the Tribunal in Phillips Petroleum who followed this method of valuation. The reference has to be drawn for the discount rate to be used in DCF while discounting the cash flows in the case of Oil and Gas enterprises.
- Valuation date and use of
Since states (or parties) are tempted to act opportunistically, when business conditions are expected to improve or have already improved, the use of valuation dates at the time of valuation and the use of hindsight information is an important element to prevent opportunistic takings.
- The selection of valuation dates and to what extent the expert should use the benefits of hindsight information in performing a valuation is of considerable importance in oil and gas cases, given the volatility of crude prices.
- Use of "Hindsight information" in case of calculating damages in Energy disputes & arbitrations; in various arbitration awards involving energy disputes (CMS v. Argentina, Sempra v. Argentina, and Enron v. Argentina), the tribunal actually relied on valuation exercises that used hindsight information to determine damages.
- Interest Rate/ Cost of
The cost of capital is nothing but the Weighted Average Cost of Capital (WACC). Using WACC provides the oil and gas investor an interest compensation that, on average, is equal to the cost of sourcing capital in its industry, and thus, on average, this compensation should restore the opportunity cost of money in its business.
- Sensitivity Analysis
To conclude, it is always a Price vs. Value test that any of the investment analysis should pass, Price being the outcome of using the combination of one and/or all of the yardsticks compared to the Value being the target to be achieved out of the acquisition in question. Hence, a proper FMV determination should consider the time element of the revenue stream and the technological, economic, and political uncertainties coupled with the conventional way by making an adjustment with check lists to account for operator experience, market outlook, equipment condition, and any other concern specific to the transaction being analyzed. It is often observed by many experts in the sector that while calculating the range for the probable price for the acquirer/ purchaser, none of the investment analysis tools are adequate when used alone. Use of yardsticks has shown that investment assumption can be made that will condemn a project when measured by any single method. A single yardstick in itself is fallible and should not be considered as an adequate measure of an investment. If the assumptions are reasonable, it is difficult to destroy all the yardsticks with a single set of assumptions. Furthermore, the results of several yardsticks are highly recommended to eliminate as much uncertainty as possible. Towards an end, nothing is more reliable than the estimates of future oil and gas prices on which they are based.
1. Phillips Petroleum v. Iran, Statement by Judge Khalilian,
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.