TRENDS, INPUTS, AND ASSUMPTIONS

SEENU AKUNURI, KEVIN CANNON, ANDREW HOWARD, ANDREW HALL, PWC, HOUSTON

THE LAST 18 MONTHS have been challenging for the oil & gas exploration & production (E&P) industry. From its recent high in early-to-mid 2014, the spot WTI oil price has declined by more than 60%; the Henry Hub natural gas price has likewise fallen dramatically during this time frame. This decline in commodity prices has been brought about by a number of factors, including but not limited to: increased drilling activity from US shale sources over the last several years; continued drilling and production from OPEC countries over their agreed upon quotas; the relative strength of the US dollar; and recent declines in global demand, particularly in large economies such as China. The recent lifting of the export ban for crude will help bring parity between US production and the rest of the world, however, this still does not solve the demand and supply equation. This article examines these trends, key inputs and assumptions utilized in company and asset valuations.

Oil & gas price performance, market capitalization

Figure 1 shows the relative performance of publicly traded E&P company indices and the correlation to WTI spot crude oil. As would be expected, smaller, less diversified E&P companies have seen their market capitalizations decline at a faster rate than those of larger, more diversified companies during this time frame. In early 2015, there was some expectation that the current downturn in oil prices might see a faster, "V-shaped" recovery, as shown in the slight rebound in WTI as well as overall market capitalizations. However, this rebound proved to be short-lived, as by May/June 2015, prices began to decline once again and the prevailing thought since then has been that recovery in commodity prices will be either be a longer and slower, "U-shaped" trajectory or it may be a while before prices recover to levels seen in early 2014.

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Figure 2 shows the relative performance since the beginning of 2014 of the Henry Hub spot natural gas price together with gas-weighted micro-, low/mid- and large-cap publicly traded E&P stock indices. Again, as would be expected, smaller, less diversified E&P companies have seen their market capitalizations decline at a faster rate than those of larger, more diversified companies during this time frame.

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Valuation multiples

As shown in Figure 3, E&P valuation multiples increased from 2010 through 2013 as strong commodity pricing bolstered oil and gas valuations. These multiples declined in 2014 and 2015 as prices weakened. Daily production multiples have declined more than proved reserve multiples, as producers remain reluctant to curb production even amidst falling prices and valuations.

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Strength of the US Dollar

Figure 4 illustrates the growing strength of the US Dollar juxtaposed with the decline of crude prices as well as the trends observed in oil and gas specific valuation multiples. The strength of the US Dollar remains a trend to continue to monitor as the Federal Reserve recently raised interest rates.

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Supply & Demand

Figures 5 and 6 illustrate some of the underlying supply and demand factors driving the commodity price decline seen from the middle of 2014 through the end of 2015. Figure 5 illustrates that OECD nations are increasing production relative to the non-OECD nations. Conversely, Figure 6 illustrates the trend of demand shifting away from OECD nations towards non-OECD nations.

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Factors influencing commodity supply and demand include decisions made by OPEC, Iran production forecasts, as well as increased shale production. OPEC announced in early December 2015 that they would not set a production ceiling. Analysts predict that the impending lift of Iran sanctions could bring an estimated 1 MMb/d to market. Additionally, important economic measures have recently indicated that China is no longer seen as a reliable catalyst for global demand.

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Related to shale production, analysts believe that supply is more elastic now due to unconventional plays; supply can react to price movement more quickly inhibiting the ability to maintain extended oil price rallies. Technical innovation as well as reduction in production costs have led to increased industry efficiencies. Expansion of both on-and-offshore commodity storage has enabled producers to continue operations, further increasing supply. All factors have led to increased overall shale production.

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Figures 7 and 8 show the growing trend in US horizontal (also known as unconventional) drilling, both in terms of well trajectory and total shale production. The rapid rise of horizontal drilling has given OECD nations the ability to add significantly to global supply, thus creating the worldwide surplus of oil shown in Figure 9.

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E&P company and asset valuation basics

The aforementioned economic forces have impacted the valuations of publicly traded E&P companies. The following section of this article will briefly review the fundamentals of valuing individual E&P assets and privately held E&P companies, and will examine recent trends seen in valuation inputs and assumptions.

In this context, companies and assets are valued utilizing one of three valuation approaches: the income approach, the market approach, and the cost approach.

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The income approach is used to estimate value based on the present value of future economic benefits, or cash flows, that are expected to be produced by an asset or business entity.

The market approach is used to estimate value through the analysis of recent sales of comparable assets or business entities. Certain types of assets may trade in active secondary markets. As such, sale price information is readily available for a comparative analysis. The value of a business entity may be estimated by comparing it to publicly-traded companies and/or to publicly-disclosed business mergers and acquisitions in similar lines of business. The value of the business entity is based on pricing multiples of certain financial parameters observed in the comparable companies.

The cost approach provides a systematic framework for estimating the value of tangible or intangible assets based on the economic principle of substitution: no prudent investor will purchase an existing asset for more than it will cost to create a comparable asset. Under this approach, value is estimated by developing the cost to either replace or reproduce (replicate) the asset as if new, and then quantify reductions in value associated with various forms of depreciation.

The income approach is generally the preferred, and most commonly used, method of valuing E&P companies and assets. Market approach indications of value may provide some insights and corroboration for other methods, however in an E&P context it is typically not as supportable as an income approach analysis because of significant differences from one company to another in such aspects as asset profiles and pricing differentials.

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Recent income approach trends

The results of a recent study performed by PwC indicated that within income approach analyses performed on E&P companies and assets from 2010 to 2015, meaningful trends existed for both the Proven Undeveloped (PUD) reserves and Probable reserves. As it pertains to reserve risking, PwC's study noted that median risking percentages have generally increased over time. This trend is most easily observed for the PUD and probable reserve categories. As outlined in Figure 10, median volume risking percentages approximated 80% for PUD reserves in 2010 and 2011, but increased closer to 90% by 2015. Opex and Capex risking percentages likewise increased between 2010 and 2015.

Additionally, as seen in Figure 11, median revenue risking percentages approximated 40% for probable reserves in 2010 and 2011, but increased to approximately 60-65% by 2015. The definition of proved reserves, as set forth by the SEC in Rule 4-10 of Regulation S-X, implies that the average risking of the overall proved reserve category should not be less than 90%; the definition of probable reserves set forth by the SEC implies that the average risking of proved plus probable reserves should not be greater than 50% (i.e. a 50% probability of producing an amount of hydrocarbons equal to or greater than the volume estimated for proved plus probable). This risking trend is important to monitor going forward as recovery techniques become more sophisticated and companies favor projects that have a greater level of certainty given the current price environment.

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Other key findings from PwC's study of income approach inputs for years 2010-2015, were as follows:

The vast majority of companies over time utilized the NYMEX strip as the basis of their commodity pricing forecasts;
The majority of companies utilized a weighted average cost of capital (WACC) as the basis of their discount rate;
Post-strip annual pricing inflation ranged from less than 1% to 3%; and
Implied acquisition control premiums varied during the period covered by the study.

Key Considerations Surrounding the Industry

Key ongoing considerations which will have an impact on E&P valuations include the factors noted above, namely the impact of OPEC's actions, the impact of additional volumes contributed by Iran, and whether demand will increase enough to absorb current levels of production and have a meaningful impact on current storage volumes.

Additionally, Management Discussion and Analysis (MD&A) sections within public filings are becoming more robust regarding the commodity environment, particularly around foreshadowing in the context of goodwill and asset impairments.

In the current pricing environment, some companies have been placing greater reliance on third-party consulting and brokerage commodity price forecasts. However, the NYMEX Strip is a Level 1 input pursuant to ASC 820 and is therefore more auditable and supportable from an audit review perspective.

Additionally, Technical PUD's could become more of a regulatory focus in the coming years. As cuts to capital expenditure budgets continue, these types of reserves might not be drilled as extensively, drilling plans will get pushed further into the future, and they will then have to be classified more closely with Probable, rather than PUD, reserves.

Conclusion

Since the downturn in commodity prices in 2014, E&P asset and company valuations have likewise seen significant declines. Global economic forces, including continued increases in drilling activity and relatively weak demand growth in OECD countries, have led to an imbalance between commodity supply and demand. This imbalance could lead to low commodity prices for a longer period of time than initially expected. In addition to the inputs discussed earlier in this article, including pricing, risking and discount rates, companies should also keep in mind that there is typically a lag between price and expense declines, such that operating margins may continue to be negatively impacted for some time. Under the current market environment, with greater likelihood of goodwill and asset impairments, E&P companies can expect greater scrutiny to be applied to valuation analyses and their inputs and assumptions.

ABOUT THE AUTHORS

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Seenu Akunuri is a principal in PwC's Transaction Services Valuation practice and has nearly 20 years of experience in the valuation of businesses in a variety of industries, including oil and gas. Akunuri has consulted with clients on complex valuation issues around structuring, buy-side, sell-side, tax and financial reporting purposes. Akunuri holds an MBA with a concentration in Finance and Accounting from Tulane University.

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Kevin Cannon is a director in PwC's Deals practice based in Houston. He has 11 years of experience performing business and asset valuations and providing corporate finance consulting. His specific experience includes valuations of businesses and intangible assets for purchase price allocations, impairment, and tax planning purposes with a focus on oil & gas and oilfield services.

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Andrew Howard is a senior associate in PwC's Transaction Services Valuation practice, specializing in the appraisal of businesses and providing corporate finance consulting services. Howard assists clients in navigating complex valuation and financial matters related to M&A, divestitures, and capital offerings.

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Andrew Hall is an experienced associate in PwC's Transaction Services Valuation practice, specializing in the appraisal of businesses and providing advisory services to a broad spectrum of oil and gas clients. He supports PwC's Energy Valuation Practice, performing valuations and strategic value consulting around restructurings, buy-side, capital offerings, tax and financial reporting purposes for both corporate and private equity clients.

Upstream valuations in the current environment

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