The lower commodity price environment over the last two years has presented challenges for valuing oil and gas reserves and unevaluated acreage acquired by E&P companies. For financial reporting purposes, the primary method for valuing reserves is the income approach via the discounted cash flow method, whereas unevaluated acreage is typically valued using the market approach via the comparable transaction method.
The challenges presented by the decline in commodity prices primarily relate to undeveloped reserves, given the amount of capital required to develop them. As such, the income approach is no longer an absolute in arriving at a reasonable value conclusion for undeveloped reserves.
In some instances, no value, or even negative value, is computed when using the income approach once fair value adjustments are considered.
Herein, we explore an alternative way to think about the value of undeveloped reserves when the income approach indicates nonsensical conclusions.
Fair Value Guidance
The standard of value for financial reporting is fair value, which is defined under Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures, as “the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.”
Under ASC 805, Business Combinations, the guidance requires value to be allocated to all acquired assets when separately identifiable.
For each reserve category, the starting place for the discounted cash flow method is a third-party reservoir engineering reserve report or a company’s internal reserve report. Often in transactions, additional resources are bought and sold including contingent and prospective resources or, unevaluated acreage.
Unevaluated acreage is typically valued with a dollars-per-acre method, a form of the market approach, and the most comparable transactions are relied upon when concluding on the metric to be applied.
In the current low-commodity price environment, unproven reserves, and in some cases even proved undeveloped (PUD) reserves, yield an uneconomic value using the income approach once fair value adjustments have been considered, for example:
- Forward price curve;
- Risking/reserve adjustment factors;
- Incremental general and administrative expense;
- Income taxes; and
- Discount rate
Although the lower commodity price environment has largely affected the economics of many drilling programs, there would still be value in transactions—if separately identifiable– involving PUD, probable, and possible reserves as well as unevaluated acreage Therefore, an alternative method to consider when the income approach yields little or no value for PUD, probable, and possible reserves is the market approach to estimate the value of the acreage underlying the reserves.
This approach suggests the notion that acreage value is the floor value for PUDs, probables, and possibles. The rationale being, engineered reserves should have at least as much value (if not more) than unevaluated acreage.
The Market Approach
The market approach, which is commonly viewed by valuation specialists as a secondary method for valuing reserves, has become more commonly used, potentially even as the primary indication of value for undeveloped reserve categories for the reasons previously discussed.
The market approach measures value through the use of market multiples, prices and other relevant information involving identical or comparable companies, assets, or transactions. The selection of the appropriate multiple requires judgment, considering qualitative and/or quantitative factors.
Valuing PUD, probable, and possible reserves using the market approach is similar to valuing unevaluated acreage as comparable transactions are assessed to conclude on a dollars-per-acre metric. The concluded dollars-per-acre metric is then applied to the number of net acres represented by the reserve category to measure fair value.
In determining the appropriate dollars-per-acre multiple to apply to PUD and unproven net acreage, common considerations include:
- Date in which the transaction occurred (transactions occurring more than one year ago may not be considered relevant);
- Oil and gas mix;
- Whether acreage in a given county varies in value (i.e. township, prime vs. non-prime acres);
- Current lease bonus, lease term, expiration; and
- Likelihood of renewal.
Given the subjectivity in valuing undeveloped reserves and unevaluated acreage using the market approach, especially in the current price environment, the more robust the analysis performed, the better. Where possible, valuation assumptions should be supported by qualitative and/or quantitative support.
Multiple sources should be considered in determining fair value and the selected multiples should be those that are the most comparable to the subject asset (i.e., transaction type, asset type, announced/closed date, and location).
This article first appeared in the Oil and Gas Investor.