From ESER oil and gas
The difference between fair market value and present worth value
- The present worth value of an oil and gas property is derived by discounting the annualized net cash flow stream of the asset.
- The present worth value represents the value to a specific group of individuals who have an economic interest in the property.
- The value to a prospective buyer -- the fair market value (FMV) -- may be something entirely different.
- In this context, the present worth value of an oil and gas property may be little more than a bargaining point.
What is Fair Market Value?
- Fair market value is the price at which an oil and gas property would change hands between a willing buyer and a willing seller.
What are some methods for determining Fair Market Value?
Rate-of-Return Method
- This method calculates that purchase price which provides for an acceptable rate of return on investment both before and after taxes.
- The objective is to determine an interest rate that makes the present value of net receipts equal to the present value of the investments.
- Rate of return has several advantages as a measure of profitability.
- Rate of return takes into account the time value of money and is a useful measure of relative profitability of investments that have similar total life and cash flow patters
- Rate of return is also useful for comparing an investment with a "minimum" alternative, such as a corporate target annual growth rate or the cost of capital.
- The disadvantages of rate of return include:
- Rate of return is independent of the magnitude of the cash flows. The rate of return for an investment that yields millions of dollars could be the same as for an investment that yields thousands of dollars.
- Therefore, other metrics, such as Net-Present-Value, payout, and profit-to-investment ratio must be used in conjunction with the Rate-of-Return method.
- Another disadvantage of the Rate-of-Return method is that the computed rate is very sensitive to errors made in estimating the initial size of the investment and the eary cash flows.
- Yet another consideration when using Rate-of-Return is that the cash flows from an investment opportunity must be reinvested as the computed rate of return when received so that the initial expenditure will have the earning power at the rate of return given.
- For example, if an Oil company does not have sufficient reinvestment opportunities at a rate of 50% for the next 12 years, rate-of-return may not be a realistic measure of profitability for the company.
Considering dry-hole risk in a rate-of-return calculation
- The initial investment rate can be increased to include monetary losses for the case in which no cash revenues are received from the project due to unsuccessful efforts.
- A pseudoinvestment at time zero (the time of initial investment) can be set to account for the cost of drilling a dry hole.
- This additional pseudoinvestment that accounts for dry-hole risk can be calculated as follows:
[(1-p)/p] * L
- Where:
- p is the probability that the oil well will be drilled successfully (in other words, the probability that the future cash flow will occur)
- L is the investment loss if no future cash flow is generated
- Considerations when using risk-weighted rate-of-return calculations:
- A weakness of using pseudoinvestment in rate-of-return calculations is that it does not take into account the possibility for discovering varying levels of hydrocarbons.
- More realistic methods for incorporating risk exist.
Profit to Investment Ratio Method
What is Profit-to-Investment Ratio?
- Profit to Investment Ratio is defined as the ratio of the total undiscounted net profit to investment.
- Unlike payout, the profit-to-investment ratio reflects total profitability of the oil and gas project.
- The Profit to Investment Ratio of an oil and gas project can be calculated as follows:
Undiscounted-Profit-to-Investment-Ratio = (Total net cash revenues - Investment) / (Investment)
- Another variation of this ratio is to calculate the Net-Income to Investment Ratio as follows:
Net-Income to Investment Ratio = (Net Income) / (Investment)
How is the Profit-to-Investment Ratio used in evaluating oil and gas projects?
- The Profit-to-Investment Ratio is routinely used with the payout method to evaluate oil and gas investment opportunities.
- An oil and gas industry rule-of-thumb is that an acceptable investment opportunity pays out in 2 or 3 years (or less) and yields a net-income-to-investment-ratio of greater than 2 to 1.
What are the disadvantages of using the Profit-to-Investment Ratio method?
- The major weakness with profit to investment ratio is that it does not reflect the rate of earnings of income from the oil and gas project.
- For example:
- Two oil and gas projects could have the same profit-to-investment-ratio and payout-time.
- However, one project could return total income in half the time as the other.
- Therefore, the profit-to-investment ratio method must be used with other measures such as Net-Present-Value and rate-of-return to properly evaluate the net cash flow stream of an oil and gas property.
Specified Fraction of Present Worth of Future Net Income Method
- This is a method for determining the Fair-Market-Value of an oil and gas property for purposes of acquisition and divestiture.
- By this method, the fair market value of an oil producing property is calculated to be a specified percentage of its present worth.
- A common rule of thumb is that the fair market value of a petroleum producing property is 2/3 of its present worth.
Price per Barrel of Reserves in the Ground Method
- With this valuation method, gas volumes are converted to equivalent barrels of oil (BOE) on either a heating value (BTU-equivalent) or price-ratio basis.
- It is worth noting that these two ratios can be divergent based on the current state of the coal, oil, and gas markets.
- For instance, a barrel of oil usually has a 6-to-1 energy equivalency with 1mcf of gas. However, the price-ratio-equivalency may be 12-to-1 or even 20-to-1 -- in the later case, it may be said that natural gas is competing with coal instead of oil. It should be noted that any percieved arbirtrage opportunities here may be illusory -- the volumetric energy density of oil far exceeds that of gas and coal, even though natural gas has a much greater energy density that petroleum on a per-kilogram basis; in applications where space is at a premium -- such as in small vehicle transportation -- petroleum-based fuels may have no viable substitutes. An offsetting factor here is that the conversion-efficiency of combined-cycle (and simple-cycle) gas turbines far exceeds that of both coal-burning and petroleum-burning systems.
- A rule of thumb is that oil reserves in the ground are worth one-third the current market value.
Discounted Profit to Investment Ratio Method
- The discounted profit to investment ratio is derived by dividing the Net-Present-Value by the present value of the investment.
- DPV (discounted profit to investment ratio) represents the amount of discounted net profit generated in excess of the average opportunity rate per dollar invested.
- DPR is useful in maximizing profit per dollar invested when capital is limited.
- The discounted-profit-to-investment ratio is also known by the following names:
- Present Value Ratio
- Present Value Index
- Percent Present Value Profit
How does DPR compare to NPV?
- NPV is preferred to other metrics because it uses a single discount rate that provides a more realistic measure of true profitability.
- However, because capital is limited investments should be made on the basis of maximizing profitability per dollar invested.
- DPR is therefore the most representative measure of true earnings potential of an oil and gas project.
- Sound investment strategy dictates that oil and gas projects should be chosen that maximize the discounted profit to investment ratio
What is an example of calculating the Discounted Profit to Investment Ratio?
Discounted net profit = $1,000,000 (at a 10% discount rate)
Initial investment = $2,000,000
Discounted profit to investment ratio = $1,000,000/$2,000,000 = .50
Discounted net income to investment ratio = ($1,000,000 + $2,000,000)/($2,000,000)
Present Worth at a Specified Discount Rate Method
- With this method, fair market value of the oil and gas property is calculated as the present worth of the investment and its future cash flow at a discount rate of between 15% and 25%.
Going Unit Price Method
- Going Unit Price is based on a percentage of the future undiscounted revenue from the oil and gas property.
- With this method, fair market value for newer properties is calculated at up to 40% of the future undiscounted revenue.
- The fair market value for older oil and gas properties is calculated at around 25% of the future undiscounted revenue.
Price per Barrel per Day of Producing Rate Method
- With this method, the Fair Market Value for the property is calculated as a dollar multiple of the current per-BOE (Barrel of Oil Equivalent) producing rate of the property averaged over the next 12 months.
- For example:
- If a property is expected to average production of 30 barrels of oil per day over the next 12 months, and
- Analogous properties in the same area have sold at a producing bbl/day purchase-price multiple of $30,000,
- Then: the fair market value for the property is:
(average production of 30 barrels of oil per day for the next 12 months) * ($30,000 per producing-barrel-of-oil-per-day purchase price multiple)
= $900,000 Fair Market Value
(DPB) Discounted Profit Per Barrel Equivalent ($/bbl)
- Discounted Profit Per Barrel Equivalent is a comprehensive metric that measures both the magnitude and time-distribution of an investment's return.
- DPB may be preferable to discounted-net-profit-to-investment because it states the distribution of profits on a per-unit-of-product basis.
(FPB) Future profit (undiscounted) per barrel equivalent ($/bbl)
- If investment capital is not limited supply, in may be inappropriate to use ROI (Return on Investment) to rank projects.
- Rather, if the limited resources is quality reserves, then FPB may be preferable to ROA as a ranking criterion.
- FPB can be used a powerful diagnostic to measure the magnitude of an investment's return.
- It should be noted that the optimum ranking sequence of projects according to future-undiscounted-profit-per-barrel may be different from the ranking according to ROI (return on investment).
Miscellaneous Fair Market Value metrics for oil and gas properties
- Risked present worth
- 3-year cumulative cash
- Present worth at 25%
- Sale price of analogous properties
Combination of FMV (Fair Market Value) Valuation Methods for Producing Oil and Gas Properties
- The Fair Market Value for a producing oil and gas property is derived by combining the methods above.
- For instance, an acceptable FMV for a producing oil property may be one which yields:
- A rate-of-return of 20% after tax
- A payout of 2 years
- A profit to investment ratio of greater than two-to-one
- Another technique for combining various FMV valuation metrics is to take the arithmetic average of three or more FMV metrics that are within 10% of each other
Deriving Fair Market Value of Oil Properties for Bank Loans
- When deriving FMV for bank loans, the amount that can be borrowed is generally below the fair market value.
- An oil property must have sufficient reserves in the ground to repay the loan in the event of a default.
- The property must also have sufficient cash-flow to reduce principal and to cover interest payments.
- Borrowing base redetermination test are performed by banks on a periodic basis. These tests may include:
- Calculating 50% of the future undiscounted revenues remaining after loan payout
- Calculating 50% of the reserves in place after loan payout
- Determining the effect on the loan after a 50% reduction in payments due to reduced product price, curtailed production or loss of production.