Property acquisitions-1: They paid how much for that producing property?

Oct. 29, 2001
How often have you uttered those words on learning the price of a winning bid for an oil and gas producing property, especially one you have evaluated or even submitted a bid?

How often have you uttered those words on learning the price of a winning bid for an oil and gas producing property, especially one you have evaluated or even submitted a bid?

On many occasions, however, subsequent events justify the price paid for acquisitions. The ongoing trend of "paying too much," sometimes known as winner's curse, is usually not the result of poor evaluation practices but of a combination of factors and techniques designed to extract the maximum value for the buyer.

Part one of this article discusses how much companies are paying for properties today compared with typical parameters used 15-20 years ago. Part two of this article, to be published next week, attempts to explain what goes into the analysis of a property valuation and why the ground rules have changed.

Authors' conclusions

  1. As with all other aspects of the upstream oil and gas business, technology has had a major effect on the asset acquisition prices paid by the purchaser of producing properties, especially those with significant "upside."
    The lower risks and costs have resulted in purchasers paying top dollar for proved reserves in order to have access to the upside potential offered by the larger properties. Valuations based on a 10-12% net present value (NPV) are not unusual, especially for high quality properties.
  2. While acquisition parameters published by the Society of Petroleum Evaluation Engineers (SPEE) may be valid for small, low quality properties, winning bids for the larger properties typically have been based on significantly lower risk-weighting factors and discount rates in recent years, especially for proved reserves. This does not appear to be coupled to classic weighted average cost of capital (WACC) estimates for discount rate, partly because WACC is usually a corporate-wide number as opposed to a discount rate for a discrete producing asset purchase.
  3. Not surprisingly, finding and development costs have dropped significantly in the past 20 years as a result of technological advances. In short the rules have changed and will continue to do so.
  4. Winner's curse or apparently paying too much for a property depends on the buyer's perspective. While the winning bid might be significantly higher than the other bids, there are often valid reasons for the winner's offer that only become apparent 5 years later.

The dilemma

Some 75% of transactions for the larger properties use the sealed bid procedure as the basis for attracting bids, said Tim Perry, senior vice-president, Credit Suisse First Boston (CSFB).1 The reasons for favoring this procedure are several.

First it allows an orderly process for the sale itself, which usually involves the execution of a confidentiality agreement, the provision of a draft purchase and sale agreement, and the opening of a data room for prospective buyers to analyze the available data.

Second, the procedure establishes a timeline for the process while not precluding the opportunity for either changing that timeline or the chance to solicit a best and final offer from the top two or three bidders at the end of the day.

Third, to the extent feasible it establishes a level playing field for all bidders and at the same time limits the degree of the seller's involvement in the process which could detract from other pressing duties.

Last and by no means least, sealed bid procedures have the reputation of attracting the highest bids for a property. This is hardly surprising. Al Escher, vice-president of services, Landmark Graphics Corp., said:

"Cost position is king in this environment (bidding for known assets). There will be few private deals to gain access to resources. Instead, access will be gained by paying more than the other contenders pay at auction. The way to grow while bidding in this market is for the assets to appear to be relatively inexpensive to you. This requires consistent development and operation of assets at lower costs than those of the other bidders."2

To put this another way, an acquisition opportunity must not be just another deal to you but one that fits your operation and your long range plan in a way that allows synergies between your current holdings and the properties for sale. In addition you must be willing to pay something for such benefits.

In today's world, many of the more traditional yardsticks for acquisition valuation no longer apply, a subject we treat in more detail later. If you find yourself constantly saying, "They paid that much for the property," you may need to re-examine your goals and aspirations if you want to be a winning bidder.

What are going rates?

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Fig. 1, derived from Scotia's US M&A database, demonstrates recent trends in the marketplace.

The figure, which shows price paid in dollars per thousand cubic feet of gas equivalent of proved reserves for predominantly gas acquisitions, demonstrates a wide disparity in price paid between small deals, characterized here as $20 million or less, in the past 12 months with the larger transactions.

Commodity prices no doubt influence these numbers, but this suggests that the larger, higher quality properties are commanding price premiums compared with the smaller and likely lower quality properties. It should be noted that Fig. 1 is based only on published information where reserves and price paid are quoted.

The next question that arises is: Have factors other than commodity price effected the recent increase in acquisition prices?

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Table 1 shows average market discount rate data from a variety of different industry sources.

The first source of data is from a paper by Diggle and David, which analyzed 40 transactions (mostly proved producing reserves) between 1983 and 1987 and observed that producing properties above $1 million sold for their conservatively estimated present value discounted at 10-12%. The authors concluded that "the fact that properties sold for a conservatively estimated present value at 10 to 12%, suggests that buyers' recent overall pretax return is a 10 to 12% rate of return and not the 25% which is often the goal."

More recent market data come from a petroleum property sales analysis report prepared by Harold W. Bertholf Inc. that includes analysis of 41 transactions in California during 1992-99. Also, the investment banking firm Donaldson, Lufkin, and Jenrette (now CSFB) has presented "Winning Bidder Valuation Criteria" used by "winning bidders to value properties" based on their experience as sell side financial advisor to clients in over 2 tcfe of asset sales during the first half of 1999.

In general, investment-banking groups such as Donaldson, Lufkin, and Jenrette (DLJ) handle most of the larger transactions and actually see the deals done. Table 1 also shows more recent acquisition valuation data from CSFB as of June 2001.

Additional market discount rate data shown in Table 1 come from a recent paper presented at the April 2001 SPE Hydrocarbon Economics and Evaluation Symposium. Ed Capen, the author, made the following observations with respect to market discount rates.

"Except for some small companies with recent large discoveries, the evidence is overwhelming that oil and gas companies in the past and still today make real returns in the area of 3% to 7%. Correct for estimates of prospective inflation (2%-3%), and assume the future will not differ much from the past. These moves lead to nominal discount rates of 5% to 10% after tax. Even leaving room for optimism about the future on the part of company executives, they would not reasonably expect an opportunity rate of 20%."

Another source of information that is often referred to in coming up with parameters for the assessment of an acquisition valuation is the SPEE annual industry survey. This survey is derived from answers to a questionnaire provided to upstream oil companies, consultants, bankers, etc., regarding predictions for future commodity prices, risk factors for reserve categories, appropriate discount rates for acquisitions, and so on. In the absence of any similar survey it is widely quoted in valuation circles. However, as well meaning as is this excellent organization, this survey falls short in two or three areas.

  1. The actual response at 140 to 250 questionnaires falls well short of a full representation of our industry with, even today, personnel involved in upstream evaluations in the thousands.
  2. Those responding in the main are no doubt involved in evaluation work, but that does not mean that the opinions expressed result in winning bids or even competitive bids. For any given acquisition there are many losers and only one winner.
  3. The opinions expressed do not differentiate between quality properties and low-grade properties.

Notwithstanding these limitations, the views expressed in terms of average risk weighting factors for reserves categories and discount rate are useful for consideration of the smaller acquisitions and in those cases where capital availability may limit the timing of further property development in line with the significant risk weighting factors for proved undeveloped, probable and possible reserves.

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Other tables (Tables 2-5) summarize additional acquisition parameters used in property evaluation. The tables compare data from DLJ and SPEE for 1999 and 2001. The difference in "winning bidder" acquisition parameters of DLJ/CSFB versus the SPEE values is noted.

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Making the assumption that the high end DLJ/CSFB risk adjustment factors shown in Table 2 equate to the highest quality properties, it can be seen that for such properties there is almost no risking for proved reserves categories with the discount rate selected only marginally above the cost of debt for the winning bids identified by DLJ/CSFB.

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In contrast the value attributable to probable and possible reserves is more limited in the winning bids than might be suggested by the SPEE survey. This could be the result of the fact that independent reserves estimates are often confined to the proved category and while significant probable-possible reserves may exist, the apparent concept is to pay the absolute maximum for proved reserves and little or nothing for the lesser categories, relying on those lesser categories, as yet not fully defined, for a decent return down the road.

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Additional market discount rate data from reports prepared by Richard J. Miller and the Texas Comptroller of Public Accounts - Property Tax Division are shown in Table 1. The Miller data are based on 231 transactions in California during 1983-99.

The Miller and Texas Comptroller data are anomalously high relative to the other sources of market discount rate data shown in Table 1. It is unclear from the information contained in the two reports as to reasons for the rather large differences. However such returns are ultimately achievable when subsequent field development occurs, a subject discussed in part two of this article.

Most of the foregoing analysis has referred to US based property transactions. The international picture may not be much different. In general, international properties sales tend to be larger since many of the fields themselves are substantial in size.

In some areas, probable reserves assume a far more prominent role, especially offshore in hostile environments where significant investment decisions for platforms and infrastructure have to be made early on, rather than one well at a time. Often the use of 2P reserves (probabilistic proved plus probable) is the estimate used for such decisions. Interestingly enough this concept has spilled over into the acquisition marketplace. Harrison Lovegrove, an investment-banking group based in the UK, recently quoted the acquisition market there as follows:

  • Full value for 2P reserves and little or no value for possible reserves.
  • Oil price forward curve for 12-18 months, then WTI at $18-22/bbl.
  • Gas price dependent on location, contract, and status.
  • Tax generally no change.
  • Inflation rate 2-3%.
  • Discount rate 10-12% nominal.

Apart from the inclusion of probable reserves to the picture, this mirrors fairly closely the acquisition parameters compiled by DLJ. As probabilistic reserves become more common in the US, especially in those situations where a producer has rights to an entire field (a situation more suited to probabilistic analysis), this trend could occur in the US.

Next week: Why bidders are assigning significant value to development potential not currently carried as proved reserves.