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Business Valuation Review             Volume 28 • Number 1             © 2009, American Society of Appraisers             ...
Oil and Gas Company Valuationscapitalizes all exploration spending regardless of the        considered where cash income t...
Business Valuation ReviewNonproved Reserves                                               in late 2009). When the pretax c...
Table 2                                                                                Sample Publicly Traded Guideline Co...
Business Valuation Review                                                       Table 3                                 Gu...
Oil and Gas Company Valuationsmultiples at the high end of the group and have applied      Summarythose multiples in Table...
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Oil And Gas Company Valuations Business Valuation Review

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The purpose of this article is to provide an overview of
the special issues involved in this industry and to educate
appraisers unfamiliar with these types of companies on
the basics of E&P valuation.

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Oil And Gas Company Valuations Business Valuation Review

  1. 1. Business Valuation Review Volume 28 • Number 1 © 2009, American Society of Appraisers Oil and Gas Company Valuations Alex W. Howard, CFA, ASA, and Alan B. Harp, Jr., CFA, ASA This article provides a primer on the analysis and valuation of exploration and production companies and related reserve engineering reports.Introduction with drilling. The working interest must pay all of the Based in Houston, Texas, our firm is particularly active costs of exploring for, developing, and producing oil andin oil and gas company valuations, now primarily known gas. Working interests can be further classified as “operat-as exploration and production (E&P) companies. Like ing” or “nonoperating” working interests. The operatingmost appraisal firms, we are generalists, but we have working interest influences day-to-day operations of thefound that the skill set necessary to perform an E&P valu- well or lease. Operating interests can be more valuableation is highly specialized. The valuation tools we feel than nonoperating interests in fields where significantcomfortable applying in almost any other industry are not development activities are required (since the operatorusually appropriate or adequate for the valuation of an has the exclusive right to control the exploration activitiesE&P company. Significant scientific and technical issues and pace). Operating interests are basically controllingare involved in the evaluation of information, due dili- interests, and nonoperating interests are like minority andgence, and nomenclature. There are very few, if any, other noncontrolling interests. The operator also has the rightindustries that require training to interpret a press release. to collect standard overhead charges (known as COPASThe purpose of this article is to provide an overview of charges) from other working interest holders that can bethe special issues involved in this industry and to educate beneficial to the operator. Royalty interests are createdappraisers unfamiliar with these types of companies on when the mineral interest owner leases a property andthe basics of E&P valuation. are passive in nature not requiring the owner to share in drilling or monthly operating expenses. A royalty takesAn Overview of E&P Firms preference over all other payments from lease revenue. E&P firms represent the “upstream” aspect of the They represent payments to mineral owners to drill onenergy industry. Pipeline and marketing firms are known their property and typically represent a one-fourth to one-as “midstream” companies, and refiners and petroche- eighth interest in gross revenues after taxes. Royalties aremical companies are considered “downstream” partici- similar to a triple-net lease. Overriding royalty interestspants. (ORRI) are like royalty interests except these expire once The primary assets of an E&P company are its oil and the lease has become uneconomic.gas reserves, that is, hydrocarbons below the surface that Methods of Accounting: Successful Effortshave not yet been produced and are economically viable versus Full Costto extract. E&P firms are unique in that their primary Financial statements of E&P firms prepared in accor-asset base is depleting and therefore must be continually dance with generally accepted accounting principlesreplaced through either drilling activities or acquisition. (GAAP) may utilize either successful efforts or full cost Ownership interests related to reserves can be held in a accounting for oil and gas reserves. These methods differvariety of forms including working interests, royalty (or in the treatment of specific operating expenses relatingmineral) interests, and overriding royalty interests. Work- to exploration costs (as opposed to acquisition or devel-ing interest owners share in the profits after the royalty opment costs, which are capitalized in both methods).interest payment, lease operating expenses, severance and Exploration costs are costs relating to carrying and retain-ad valorem taxes, and capital expenditures associated ing undeveloped properties, costs of the collection andwith a property (lease/well) as well as the risks associated analysis of geophysical and seismic data, and costs incurred with drilling an exploratory well. The successful Alex W. Howard, CFA, ASA, Senior Managing efforts method capitalizes only those exploration costsDirector, and Alan B. Harp, Jr., CFA, ASA, Managing associated with successfully locating new reserves. ForDirector, are with Howard Frazier Barker Elliott, Inc., in unsuccessful (or dry hole) results, the associated explora-Houston, Texas. tion costs are immediately expensed. The full cost methodPage 30 © 2009, American Society of Appraisers
  2. 2. Oil and Gas Company Valuationscapitalizes all exploration spending regardless of the considered where cash income taxes and capital expendi-outcome. tures are deducted from EBITDAX.Analyzing Financial Statements Reserves and Reserve Categories When analyzing historical financial statements, it is Reserves are classified as either (1) proved or (2)useful to include historical production volumes as well as unproved.the average hydrocarbon prices received for the periods inquestion. Since hydrocarbons are a commodity, the phys- Proved Reservesical volumes indicate whether the company is producing Proved reserves are quantities (volumes) of oil ormore or less, regardless of revenue increases resulting natural gas that are recoverable in future years fromfrom price increases. Production volumes are typically known reservoirs under existing economic and operatingexpressed as barrels of oil equivalent (boe) or thousands conditions. Proved reserves are classified into threeof cubic feet equivalent (mcfe) for gas. Conversion of gas categories:to oil equivalent is typically based on 6,000 cubic feet 1) Proved Developed Producing (PDP) reserves are(mcf) of gas per one barrel of oil, roughly equivalent to expected to be recovered from completion intervalsthe British thermal unit (BTU) conversion. (oil- and gas-producing sands or zones) that are Also various analytical ratios can be calculated such open and producing at the time of the estimate.as lifting costs (lease operating expenses per boe or mcfe PDPs are the only reserve class generating currentproduced during a period) and finding costs (costs associ- cash flow or EBITDAX, and PDPs are the leastated with increasing reserves during a particular period). risky and therefore most valuable reserve class.As opposed to industrial companies, the quantitative 2) Proved Developed Non-producing (PDNP) reservesmeasures of E&P performance are based primarily on the include shut-in and behind-pipe reserves. Shut-inability to replace and grow resources at a favorable cost. reserves are expected to be recovered from comple-This is in contrast to profit margins and growth. tion intervals (zones) that were open at the time of Rather than EBITDA (earnings before depreciation, the reserve estimate but are not producing. Behindinterest, taxes, and depreciation and amortization), ana- pipe reserves are expected to be recovered fromlysts usually consider EBITDAX a primary pricing metric completion intervals not yet open but still behindfor E&P companies. EBITDAX represents EBITDA casing in existing wells. Such wells are usuallybefore exploration costs for successful efforts companies. producing, but from another completion interval.For full cost firms, exploration costs are embedded in Additional completion work is needed before thesedepreciation and depletion, so EBITDAX equalizes both reserves are produced.accounting types. Exploration costs in successful efforts 3) Proved undeveloped (PUD) reserves are expectedcompanies are typically labeled or referred to in the finan- to be recovered from (1) new wells on undrilledcial statements as exploration, abandonment, and dry acreage or (2) existing wells requiring majorhole costs. In addition, other noncash expenses such as expenditure. PUDs are typically not counted (orimpairments, accretion of asset retirement obligation, booked) until it is clear the well or major expendi-and deferred taxes should be added back in calculating ture will be funded and completed in the nearEBITDAX. See Table 1. Free cash flow could also be term. Table 1 General Framework for Calculating Comparable Earnings Before Income Tax, Depreciation, Depletion, Amortization, and Exploration Costs (EBITDAX) Full Cost Successful EffortsOperating Income Operating incomePlus: Depreciation, Depletion and Amortization Plus: Depreciation, depletion, and amortizationPlus: Accretion of Asset Retirement Obligation Plus: Exploration expensesPlus: Deferred Taxes Plus: Dry hole, abandonment, and/or impairment expenses Plus: Accretion of asset retirement obligation Plus: Deferred taxes= EBITDAX = EBITDAXBusiness Valuation Review — Spring 2009 Page 31
  3. 3. Business Valuation ReviewNonproved Reserves in late 2009). When the pretax cash flows in the SEC case Probable reserves (referred to as 2P reserves when are discounted to the present at a 10% discount rate, theaggregated with proved reserves) have a 50% chance that result is referred to as the “SEC 10” value of the reserves.reserves quantities will be higher than estimated and a If the purpose of the reserve study is for M&A activity, a50% chance that the reserves will be smaller in accor- different “price deck” may be considered such as futuresdance with the engineering definition of the American pricing for oil and gas (i.e., the New York MercantilePetroleum Institute. Possible reserves (referred to as 3P Exchange (NYMEX) strip pricing).reserves when aggregated with proved and probable Below is a listing of key items that we believe arereserves) reserves have a 10% chance that reserves are important to bear in mind in reviewing a reserve reportgreater than estimated and a 90% chance that reserves and its underlying assumptions:will be smaller. These nonproved categories are highlyspeculative and generally given little weight. 1) What price deck (commodity price forecast) was used for reserve report? Note that engineers doHow to Read Reserve Reports not typically build the effect of hedges or other The Pension Protection Act of 2006 reinforces and derivatives into their DCF model. The projectionsprovides penalties for appraisers who, among other may be overly conservative if the NYMEX stripfactors, accept information provided by management of a pricing is significantly higher than the oil and gascompany or other experts hired by the company without prices used in the reserve report.adequate due diligence. Therefore, when valuing E&P 2) How do the projected volumes compare with his-companies the appraiser must have the basic knowledge torical production volumes? If materially different,to converse with petroleum engineers in order to under- ask why.stand the basis for their conclusions. This section seeks to 3) Are PUDs included in the analysis? Are probableprovide some basic understanding of the reserve report. and possibles (3P) included in the projections? Unlike third-party appraisal reports, many petroleum What drilling and capital expenditure assumptions(or reservoir) engineers do not determine the fair market were utilized in developing the projectionsvalue of reserves. Rather, they provide gross quantities associated with the PUDs?expected to be produced from wells, net such quantities 4) How concentrated is the production by well,to the subject company’s ownership interest, and make by field, and by region? Generally, the moreestimates of future prices, operating expenses, and capital concentrated the production, the higher the risk.expenditures. Essentially the reserve report is a discoun- If one or only a few wells represent a significantted cash flow (DCF) model for the subject company’s portion of the projected cash flow, a risk adjustmentreserves, on a pre-income tax basis. Appendix I presents is warranted.a typical summary data table from a reserve report pre- 5) How did the engineer consider plug and abandon-pared by Netherland, Sewell & Associates, Inc. (NSAI), a ment costs? GAAP balance sheets refer to thishighly regarded worldwide petroleum engineering firm liability as the asset retirement obligation.based in Texas, who provided permission to reproducetheir sample report in this article. Using this table of data, 6) If the engineer is not providing an opinion of fairthe analyst can calculate total proved reserves (33,969 market value, we often question the engineer asbbls of oil and 8,772,300 mcf of gas or total proved to what discounts to the PV-10 value would reflectreserves of 8,976,114 mcfe) of about 9 bcfe and the per- market value. In the industry, such discounts arecent gas at 98%. Firms such as NSAI are engaged to referred to as “haircuts.”conduct reserve studies for various reasons including the Typical Valuation Approaches and Methodologyfollowing: (1) year-end reserve studies for GAAP orSecurities and Exchange Commission (SEC) purposes, E&P companies are commodity businesses which(2) bank or other financing purposes, and (3) merger and have no control over the prices they receive. They mayacquisition (M&A) and related valuation activity. The vary their production and capital expenditures based onpurpose of the study can influence the inputs into the DCF current and future price expectations and can hedge theirmodel. For example, SEC reserve reporting requires the reserves by utilizing the futures market. The primarypetroleum engineer to develop the DCF model using oil method we use to value E&P firms is the Marketand gas prices in effect at the evaluation date (typically at Approach because of the availability of reliable pricing31 December) and hold such prices constant throughout and operating data.the long-term projection period (certain changes with We do not typically use the Income Approach directlyrespect to SEC reserve reporting go into effect beginning since the reserve report is in fact a form of the IncomePage 32 © 2009, American Society of Appraisers
  4. 4. Table 2 Sample Publicly Traded Guideline Company Method (E&P Companies) in Millions $ Proved Reserves Proved Projected All-in Oil Developed EV/ EV/ Primary Areas (Current Lifting Finding Equivalent Reserves/ R/P Market Enterprise EV/ Proved Daily of Year) Cost Cost Debt/ (MM Mix Total Ratio Value of Value Projected Reserves Production a b c Company Production EBITDAX LOE/Bbl per Bbl Total Cap boe) Oil % Reserves (Years) Equity (EV) EBITDAX (boe) (boe/day)Business Valuation Review — Spring 2009 Comparable Diversified U.S.A. no. 1 and international $3,217 $8.05 $14.60 25% 880 37% 74% 12.0 $6,500 $7,400 2.3× $8.40 $32,000 Comparable Diversified U.S.A. no. 2 and international $1,926 $12.60 $16.00 45% 970 48% 61% 23.5 $2,600 $5,200 2.7× $5.40 $43,000 Comparable Diversified U.S.A. no. 3 and Canada $1,364 $9.20 $16.30 49% 372 25% 69% 15.0 $2,000 $4,500 3.3× $10.40 $45,000 Comparable Diversified U.S.A. no. 4 and international $1,870 $13.60 $18.50 37% 425 27% 63% 10.0 $2,500 $4,300 2.3× $10.50 $37,000 Comparable no. 5 Diversified U.S.A. $893 $21.50 $15.00 41% 250 78% 67% 17.0 $1,400 $2,500 2.8× $9.20 $50,000 Subject Company Rocky Mountain $90 $13.50 $15.00 15% 19 56% 25% 25.0 Bbl = barrel, boe = barrels of oil equivalent, MM = million. a Lease operating expenses per barrel. b Three-year average all-in finding costs: costs incurred for acquisitions, exploration, and development divided by sum of reserve extensions, additions, and revisions. Stated on a $/boe basis. c Oil-to-gas conversion ratio: 6 mcf = 1 bbl.Page 33 Oil and Gas Company Valuations
  5. 5. Business Valuation Review Table 3 Guideline Company Method Application of Pricing Metrics Guideline Company Subject Company Pricing metrics Resulting Value (MM)aProjected EBITDAX (MM) $90.0 2.5× to 3.0× $225 $270Proved Reserves (MMboe) 9.0 10× to 12× 190 228Daily Production (Boe/d) 2,100.0 45,000× to 60,000× 95 126 Enterprise value 200 230 Plus: mark to market hedge value 10 10 Plus: other assets (mid-stream, acreage) 20 20 Less debt, including asset retirement obligation (35) (35) Equity value $195 $225a As if publicly traded.MM: million.Approach and due to the difficulty of modeling corporate frequency of reserve acquisitions and divestitures amonglevel income taxes for E&P firms. In the Asset Approach, the publicly traded E&P companies that could distort val-the E&P firm’s balance sheet is marked to market (the Net uation indications. Developing forward or current-yearAsset Value Method) using the reserve report. metrics often requires a time-consuming review of press This article is focused on independent E&P companies releases and other sources of information. An example ofthat are not highly diversified/integrated, with midstream the information collected in the Guideline Companyand downstream activities such as integrated majors (i.e., Method is presented in Table 2, and the application of thatExxon Mobile Corporation). Likewise, royalty trusts data to the subject company is presented in Table 3.and master limited partnerships (MLPs) are yield oriented Table 2 shows that relative to the Guideline Com-securities and not the focus of this article. panies, the subject company is small and has average The first step in working with a market approach is finding and lifting costs. The subject company is less leve-selecting appropriate guideline companies. We use the raged, and its proved reserves are mostly undeveloped,John H. Herold database (energy industry specific) to which means there are significant capital requirementsidentify comparable publicly traded companies. We related to converting the subject company’s reserves tobelieve some of the most important screening criteria cash flow–generating assets. However, the growth poten-include (1) size (in market capitalization or reserve tial is strong: the subject company’s reserves have beenvolumes), (2) gas/oil mix (the percentage of reserves found and need only to be developed. The subject com-or production represented by natural gas verses oil), (3) pany’s r/p ratio (reserve life) is high, meaning that currentreserve life (proved reserves divided by last or current production levels can be maintained for a long duration—year’s production and known as the r/p ratio), (4) the PUD longer than any of the other Guideline Companies.to total proved reserve ratio (this indicates how much of The Guideline Companies were priced (on anthe reserve base is currently generating EBITDAX), and enterprise value basis) at 2.3× to 3.3× EBITDA, $5.40(5) areas/basins of operation (i.e., onshore versus offshore to $10.50 per proved boe, and $32,000 to $50,000 boe ofactivities). production per day. Historically there has tended to be a strong correlation between the r/p ratio and the EV/EBIT-Key Pricing Metrics DAX multiple. Excluding Comparable no. 3, there is Once guideline companies are selected, the appraiser some noticeable correlation between EV/EBITDAX andshould consider the following pricing metrics: the r/p ratio. This correlation is intuitive, since reserves are depleting assets, so perhaps the correlation will return • Enterprise Value (EV)/proved reserve quantities (i.e., in time. EV/boe) Although the subject company is small and less • EV/daily production diversified, which points to greater risk, its low debt ratio • EV/EBITDAX. coupled with a long r/p ratio and high undeveloped ratioA forward or current year indication of reserves, pro- result in favorable risk and growth comparisons. Accord-duction, and EBIDAX should be utilized because of the ingly, we believe the subject company would trade atPage 34 © 2009, American Society of Appraisers
  6. 6. Oil and Gas Company Valuationsmultiples at the high end of the group and have applied Summarythose multiples in Table 3. Other considerations in thevaluation should include the potential value of undevel- Investments in E&P companies are essentially com-oped leasehold acreage or other assets (pipelines/ modity plays. Their market prices are highly correlated togathering systems and seismic data) held by the subject the price expectations of the commodities they sell. Thecompany. Table 3 also shows that the mark to market analysis therefore is based heavily on reserve life and thevalue of the hedges as of the valuation date should be ability to replace production. PUDs are the reserves thatconsidered in the valuation. Note also that the asset will fuel future reserve replacement.retirement obligation should be treated as debt and These companies are analyzed and valued on ansubtracted from EV to calculate equity value. industry-specific metric that this article has described. Appendix 1 e pl m SaBusiness Valuation Review — Spring 2009 Page 35

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