Oil and Gas Asset Valuation 101
"The evaluation of oil and gas properties is a calculation which involves many variables. The interrelationship between the variables is too complex to be described by a simple formula." Dr. William M. Cobb, P.E. President William M. Cobb & Associates
I recently read a blog post that suggested oil companies actually trade oil and gas assets based on simple yardsticks such as $ per barrel of daily production, or $ per barrel of oil in the ground, and the implication was that this is an accepted way of doing business.
This is one of many misconceptions about the oil business and one hopefully I can help clear up.These single formula yardsticks are useful for screening purposes and getting a general idea of the size of a deal, and perhaps in comparing large company stock prices, but certainly not appropriate for buying and selling assets.
When putting a price tag on an oil and gas asset its all about Cash Flow, and timing. Cash flow itself is a function of many variables:
- Production Rate and Reserves
- Product Prices
- Operating Costs
- Capital Investments
- Taxes
- Royalties
- Overhead
- Ownership
Once all of these variables are carefully evaluated the cash flow must be adjusted for the time value of money and risk to arrive at an appropriate value for a specific asset. There are a lot of moving parts and plenty of potential pitfalls to avoid, and every property has it's own unique characteristics.
An offshore asset may be worth only $20,000 per barrel of daily production while a property in West Texas could fetch $90,000 per barrel or much more. This is due to several factors: Offshore properties typically produce at very high rates for a short period of time, so while they generate a lot of cash flow it doesn't usually last long.
Also, the cost of producing a barrel offshore can be quite different than in West Texas. Then there is the undeveloped potential of the properties that need to be considered, and the cost of abandoning the wells and facilities once production has ceased. When comparing the value of assets on a $ per barrel in the ground basis, it's important to know how much investment is required to recover those barrels and sometimes that investment in itself isn't palatable to the investor.
So you can see Dr. Cobb's point-- each of these variables needs to be carefully evaluated when determining an asset's value to the investor, and using a single formula yardstick may get you close, but being close is only good enough in horseshoes and hand grenades.
In future posts I will discuss the various classifications of oil and gas reserves and why these different classes are handled differently when determining the value of an oil and gas property.
