Valuations of any business or asset can be complicated and the valuation of oil and gas interests or companies is no exception. While valuing oil and gas interests involves using the same three approaches that are used to value any business (income, market, and asset), there are unique factors that should be considered under each approach.
• Income approach – The income approach is based upon the simple concept that the value of any asset is equal to the cash it is expected to generate, discounted at an expected rate of return. Which means a valuation needs only two things: an estimate of future cash flow and a rate of return based on the risk of the investment. While this seems simple, there are many questions to be considered with regard to a valuation of oil and gas interests under the income approach. For example:
o Is the interest a working interest, royalty interest or an overriding royalty interest? A working interest shares in the revenue and expenses of the oil and gas interest as well as the risks associated with drilling, while royalty and overriding royalty interests generally receive royalty payments and do not share in the expenses or risk of drilling the wells. Obviously, the type of interest being valued will affect the future cash flow and rate of return required.
o Are the reserves proved or unproved? If the reserves are proved, that makes recovery more likely and the risks of achieving projected cash flows from the wells are reduced.
o What commodity price forecast is used and is it appropriate? The price of gas or oil is a crucial assumption in any valuation analysis and must be supported by current research. Another issue to consider is whether or not oil and gas prices have been hedged and how that should affect the valuation.
o How reliable is the reserve report? The reserve report supplies key inputs to a valuation under an income approach including gross quantities to be recovered, estimates of future prices, operating expenses, and capital expenditures, and must be evaluated accordingly.
• Market approach – The market approach attempts to answer the question, “at what prices are other oil and gas companies or interests sold?” Publicly traded oil and gas companies as well as private transactions in oil and gas interests are considered in this approach. These guideline companies and transactions are then analyzed to determine relevant multiples to apply to the subject interest. Some relevant ratios include price to proved reserve quantities or price to EBITDAX (earnings before interest, depreciation, amortization, and exploration costs).
However, the difficulty of applying the market approach is identifying truly comparable guideline companies and transactions. If there are fundamental differences between the guidelines and the subject interest, the valuation analysis loses reliability. For example, some key areas of comparability to consider include:
o Gas/oil mix.
o Reserve life.
o Proved versus unproved reserves.
o Geographic location.
• Asset approach – The asset approach generally uses the results of the income and market approaches to restate the book value of the oil and gas interests to fair market value.
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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.