ARE OIL AND GAS RESERVE VALUES FAILING?

March 19, 1990
Robert H. Caldwell, David I. Heather, Wayne A. Beninger Scotia Group Dallas The market for oil and gas reserves (properties and companies) is of interest to all oil companies who have an eye on their performance in reserve replacement. Since the 1986 oil price crash, various groups who monitor comparative sales have been reporting that the value of reserves, while tending to fluctuate with commodity price changes, has exhibited a decreasing trend (refer to Strevig's Quarterly Median
Robert H. Caldwell, David I. Heather, Wayne A. Beninger
Scotia Group
Dallas

The market for oil and gas reserves (properties and companies) is of interest to all oil companies who have an eye on their performance in reserve replacement. Since the 1986 oil price crash, various groups who monitor comparative sales have been reporting that the value of reserves, while tending to fluctuate with commodity price changes, has exhibited a decreasing trend (refer to Strevig's Quarterly Median Acquisition Price).

The discussion below illustrates the impact of 1) gas vs oil transactions, 2) reserve quality, and 3) equivalency conversion methods on "comparable sales" evaluation. Making distinctions in these three areas improves conclusions drawn from published data regarding M&A transactions to a level suitable for use in the quantitative sense. In fact, $/BOE as a unit of measure may now be considered more than just a "rule of thumb" although still less than rigorous evaluation.

Are reserves becoming less valuable as measured by the comparative sale? To year end, 1989 enjoyed an average WTI posted price of about $19.00 compared to 1988 which averaged around $15.50. Employing the 1/3rd rule (reserve sell for around 1/3rd of the posted price) one would expect sales to currently be in the $6.30/BOE range rather than a figure some 20% lower. Since the reported average (for median, the distribution is essentially normal so the mean and median approximate each other) is falling while oil prices are rising, are the averages meaningful?

To answer these questions, it is necessary to critically examine the parameters used to measure the comparative sale: the price paid and the quantity of reserves purchased expressed as $/BOE. This indicator is often maligned as a property valuation tool for a variety of reasons: not comparative for short versus long life properties, no time value of money consideration, unreliability due to lack of uniform reporting standards, requirement for geographic discrimination, etc. As a result the oil and gas acquisition community does NOT value properties using $/BOE, but rather uses the discounted cash flow as the primary tool for determining a price, as it should. However, cash flow analyses are rarely if every publicly reported. In order to track trends in the reserves marketplace, it is necessary to use the only commonly available data source, $/BOE, recognizing that this indicator is informal, imprecise and potentially misleading unless considerations such as those discussed below are accommodated.

The source of data for this analysis was the Scotia M&A Database. This database identifies about 1400 transactions from 1979 through present and contains price data on about half and reserves data on about a quarter of these. Using a 6 Mcf/Bbl equivalency, the average comparative sale was $5.11/BOE in 1988 and $5.07/BOE in 1989.

While the above represent valid numerical averages, do they represent valid trends in the mergers and acquisitions marketplace? We argue that they DO NOT unless the following are considered:

EQUIVALENCY CONVERSION MUST REFLECT PRICES DIFFERENCES

The common practice of converting gas to barrels of oil equivalent using the thermal equivalency of 6 Mcf/Bbl while the price equivalency (ratio of prevailing oil-to-gas price) is currently more in the range of 8 to 8.5 creates artificial reserve values. An example is the practice of quoting gas reserves purchases in BTU equivalent barrels. This creates more BOE's than the use of a price equivalency, hence creating a lower $/BOE for the acquisition and a pat on the back from the financial analysis. Recalculating using a price equivalency will tend to express each transaction more in line with the methods used to arrive at its price: that is, discounted cash flow analysis where each production stream is separately handled with its own pricing and price escalation. Using prevailing annual product prices for equivalency conversion, the Scotia M&A database yields $5.68/BOE for 1988 and $6.24/BOE for 1989 as the average transaction price paid.

While this is not completely correct since the ratio will vary from transaction to transaction, it is an improvement over the use of a simple BTU conversion.

GAS AND OIL TRANSACTIONS MUST BE SEPARATELY HANDLED

Gas reserves sell for a different per-unit price than oil reserves on average. While oil reserves sell for about 35% of wellhead oil price (the above mentioned 1/3rd rule), gas reserves sell for about 45% of the wellhead gas price. This is not a recent phenomenon (the positive price perception for gas versus the neutral perception for oil) but since it is observed (Figure 2) for several years we consider it a fundamental difference in the income available per unit of production of oil versus gas wells. Thus on a price equivalency basis, a greater number of gas transactions will tend to increase the yearly average while a greater number of oil transactions will tend to decrease the yearly average regardless of equivalency conversion method.

RESERVES QUALITY MUST BE ACCOUNTED FOR

High quality reserves sell for a premium while low quality reserves sell at a discount to the average. While this truism will be disputed by few, it can be difficult to prove. The annual $/BOE figures will be influenced by the mix of quality reserves transactions (mainly the larger dollar deals) pulling the average up, versus lower quality reserves transactions (mainly the smaller dollar deals) pulling the average down.

What about the geographic factors? Obviously heavy oil is less valuable than light oil and poor production less valuable than good production given the same volumes. These are the driving factors. Production is not necessarily cheaper if it is located in the Illinois Basin. It is cheaper because it is less desirable production through a combination of producing rates, operating costs and product price.

In light of the above considerations and the search for a trend in recent M&A activity, the following analysis is made:

  1. Historical activity is aver-aged on a yearly basis.

  2. Price equivalence is used to convert gas to oil or oil to gas.

  3. Oil transactions are studied separately from gas transactions.

  4. Large transactions are separated from small transactions based on a $20 million threshold.

Fig. 1 and 2 plot annual average acquisition price versus year separately for oil ($/BOE) and gas ($/MCFE) transactions and display the large, small and overall average figures.

It is evident from these graphical expressions that the answer to the original question of "are reserve values falling?" must be answered by "that depends." In the cases of both oil and gas transactions, the larger ($20 million) deals appear to attract a premium, with prices per unit averaging about half the wellhead price. The smaller deals however appear to be priced at a discount, and the overall average is dragged down by the numeric predominance of smaller over larger deals.

SUMMARY

The current M&A marketplace appears to be polarized into at least two major groups representing the larger, higher quality reserves deals attracting a premium price and the smaller, lower quality reserves deals involving discounted prices (see table). This makes any overall average sensitive to the reported mix of properties to the point where trends become totally obscured. This being the case, what conclusions can be reached?

  • Large transactions are attracting higher prices, reflecting perhaps increased confidence that oil and gas prices will continue to climb.

  • Small transactions are suffering a decreasing pricing trend reflecting perhaps increased concern over future operating cost inflation for marginal properties.

  • The $/BOE indicator can be a meaningful unit of measure but only if enough data is available so it may be applied selectively.

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