In the world of oil and gas valuation, the discounted cash flow model (DCF) is king. Rarely will an oil and gas investor make an investment decision without first analyzing the output from Aries, PHDWin or another similar software program. These programs are used by petroleum engineers to forecast production, apply various price and expense assumptions, and ultimately predict future cash flows, which are then discounted back to the present at various discount rates.

In a perfect valuation world, all oil and gas transactions would be announced publicly and presented neatly with all the various input assumptions necessary for a DCF valuation, including the allocation of value between reserve categories. A&D professionals could then more easily compare properties that have varying decline profiles, commodity price differentials and operating costs.

Unfortunately, often the only pieces of data that are received for analysis are the purchase price, net daily production and, if you are lucky, proved reserves. While anything beyond the DCF model is at best used to frame the valuation of oil and gas properties, as a decent rule of thumb, many oil and gas professionals multiply a property’s net daily production rate by a dollar per barrel of oil or dollar per thousand cubic feet of gas. The looming question then is what dollar amount per barrel or thousand cubic feet should be used to multiply by the net daily production rate to achieve this implied market value?

That question can be answered with a statistical analysis tool known as the R/P valuation formula (R/P tool). The R/P tool uses a property’s “proved R/P” (total proved reserves divided by annualized current net daily production) to determine the appropriate multiple rate and, thereby, the approximate market value or potential sale price.

Equipped with the R/P tool, an evaluator is able to compare transactions despite the absence of many important variables, including trailing-12-month cash flow, total proved PV-10 value or even the location of the properties. The only requisite inputs for the R/P tool are the current net daily production rate and the risk-adjusted total proved reserves.

How it works

For its quarterly M&A transaction report provided to industry professionals, E-Spectrum Advisors splits the transactions between majority-oil and majority-gas and then plots each transaction, with proved R/P as the x-axis (independent variable) and dollar per net daily unit of production as the y-axis (dependent variable). ESA then calculates a trend-line formula and the corresponding coefficient of determination, a measure of statistical correlation that ranges from zero (no fit) to one (a perfect fit). In each chart, the point size is proportionate to the total price. Transaction points for the last quarter are in red (to show the most recent trend) while all other points are blue.

Reviewing the past 12 months of oil-weighted transactions, it is clear that buyers are paying for undeveloped reserves. However, regarding gas-weighted transactions, buyers are not paying as much for undeveloped reserves, likely because the rates of return are low for gas proved undeveloped reserves (PUDs). The evidence for this is found in the very flat trend line shown in the gas-weighted chart.

While the R/P valuation tool is only an approximate measure of value and does not replace tried-and-true reserves analysis, with some simple math, anyone can quickly estimate the market value of a producing property, whether it is $10 million or $1 billion.

Some quick tips regarding use:

1) Take care when estimating risk-adjusted proved reserves. The number is subjective and publicly announced deals may or may not quote the buyer’s estimate of risk-adjusted reserves.

2) Separate majority-oil transactions from majority-gas transactions rather than trying to estimate value on a barrel of oil equivalent basis.

3) Remove transactions that have unique characteristics that cause them to fall well off the regression line, such as a transaction with significant value attributable to possible and probable reserve categories.

Where will your properties fall on the regression line? It depends on many factors, but generally properties with significant probable and possible reserves or significant undeveloped acreage in addition to proved reserves will fall above the line, since those nonproved reserves often increase the buyer’s value for the properties but are not included in the proved R/P ratio.

Deals lacking nonproved upside or deals with a large amount of low internal rate of return PUD reserves are more likely to fall on or below the line. In addition to the amount of nonproved upside, other factors such as lifting costs, finding costs and differentials (basis, transportation and quality) can also affect a given property’s deviation from the trend line.

Lindsay Sherrer is with E-Spectrum Advisors. Contact her at lindsay.sherrer@energyspectrum.com

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