From mineral rights and royalty interest owners to oil and gas producers and their shareholders, to local, state and federal governments, the valuation of oil and natural gas wells, leases, mineral rights and royalties are a vital part of the economic engine.
Companies offering such valuations stay busy keeping up with the changes in the nation’s oil and gas industry — changes that are coming at an increasingly rapid pace. Representatives frequently meet with clients and attend various conferences to keep abreast of developments.
Alan Harp, managing director in the Houston office of Stout Advisory, recently attended the Executive Oil Conference presented by Hart Energy so he could keep up to date on the latest trends and valuation multiples in the Permian. He also took time to answer questions on the subject of oil and gas valuations.
Reporter-Telegram: Obviously these valuations are vital to a company’s financial health, used to report their finances to both the government and investors. What processes are there to ensure these valuations are as accurate as possible?
Alan Harp: There are no industry-accepted processes or standards to ensure accurate oil and gas valuation. Each valuation provider develops their own methodologies and procedures. Ultimately, accuracy is evaluated by a financial auditor, a court, the Internal Revenue Service, or other institution depending on the purpose of the valuation.
In my opinion, one of the best processes for ensuring accuracy is to perform both an Income and Market Approach to valuation where possible. An Income Approach (the Discounted Cash Flow Method) is the approach most people think of when valuing an oil and gas property. A petroleum engineer projects future production, commodity prices, drilling and operating costs in a reserve report. Risk-adjusted discount rates or factors are then applied to generate a valuation.
The Market Approach calculates a value based on pricing multiples derived from the sale of similar properties such as price per daily flowing barrel equivalent or price per acre.
When both an Income and Market Approach are used and they point to similar valuation conclusions, some degree of accuracy is inferred. When only one of the approaches is used, there is a greater probability for error. Using both approaches is particularly useful when valuing non-producing or undeveloped properties
In an early 2017 mineral and royalty valuation, a petroleum engineer’s report inferred a valuation of less than $2,000 per net mineral acre in northeastern Reeves County. We were aware of non-producing minerals transacting in the area at the time in excess of $7,500 per net royalty acre (the $7,500 per net acre assumes a 12.5 percent average royalty rate which is equivalent to $15,000 per net mineral acre assuming a 25 percent average royalty or $60,000 per net mineral acre assuming a 100 percent royalty interest). In this case, we concluded that the engineer’s assumptions and conclusions were overly conservative and could not be relied upon for our valuation. When our engineer developed more reasonable assumptions as to the number of probable and possible locations, the Income Approach fell in line with the Market Approach.
Another form of the Market Approach involves the consideration of previous transactions for the subject property. Earlier this year, the Securities and Exchange Commission took action against a firm that valued a large acreage position in Alaska at over $450 million and failed to consider that the property had transacted within months of the valuation date at less than $5 million. The price at which a willing buyer and willing seller would transact for a particular property is the heart of fair market value.
Here’s one other example of valuing minimally developed acreage. In late 2016, we valued over 30,000 acres in the Delaware Basin using the best information available to us regarding expected well results, wells per section, expected commodity prices, and drilling and operating costs. We recently reran the same engineering analysis by updating longer-term pricing assumptions — near term prices had not changed materially — condemning certain acreage based on recent well results that we initially thought was economic, and reflecting higher than expected drilling and operating cost inflation and found that the results of the Income Approach declined over 40 percent in less than 12 months. The point I want to make with this example is that the Income Approach is not perfect and fairly minimal changes in the assumptions led to dramatic changes in valuation. The Market Approach is not perfect either, but I do believe that using more than just one valuation method leads to more accurate results.
MRT: How has the process of valuations changed in recent years? Has technology helped? Has the huge jump in domestic production had an impact
Harp: Property valuation, particularly mineral and royalty valuation, has become more sophisticated in the past five years and more data has become available. Previously, there was more use of cash flow multiples and rules of thumb. Today, sophisticated buyers and valuation people may use an engineering or drill out approach to “stick up” a property for a discounted cash flow analysis; that is, horizontal well locations are drawn across the entire property base and judgments are made as to likely drilling pace. Cash flow multiples paid for legacy vertical production often have no bearing on the true value of a property set if it is prospective for aggressive horizontal development. Said another way, the multiple of cash flow associated with the property is meaningless in certain cases because the true value of the property lies in potentially vast future production, not minor existing legacy production.
MRT. How did the “land grab” in the Permian, specifically the Southern Delaware, impact efforts to value leases?
Harp: The public land grab occurred mostly during the second half of 2016 and early 2017 in the Texas portion of the Delaware Basin (primarily Reeves, Loving, Ward, and Pecos counties) when over $15 billion was spent on leasehold acquisition. Since there was little production associated with these acquisitions, most of this amount was paid simply for the “right” to develop the properties, not for capital expenditures. That is, tens of billions more would be required to drill up and develop this acreage
During this time, valuations in the Southern Delaware were rapidly evolving, with certain transactions reflecting step changes in the understanding of the property values. First, the price per net acre was rising dramatically as the industry saw success in the Wolfcamp with longer laterals and more intense completions. Second, as is always the case, the land rush was occurring before many understood what geographic areas had the best economics. The price per acre metrics were being applied generally across the basin and resulted in overvaluation of areas that later proved to be less attractive/fringe areas.
MRT: I assume you’re closely watching the ongoing tax reform efforts in Washington. How could that affect your work, specifically in well and lease valuations and even mineral and royalty valuations?
Harp: As long as the intangible drilling cost (IDC) deduction and percentage depletion remain available (and, as of today, the House tax reform bill keeps these in place), we don’t think tax reform will have a significant impact on property valuation. We’re actually working on an article now that addresses our perspectives on the impact of income taxes on oil and gas property valuation and we hope to have it ready in early 2018.
MRT: Which is now more in demand: valuations for wells and acreage or for minerals and royalties? Or are they fairly equal?
Harp: The vast majority of oil and gas valuation matters focus on leasehold/working interest valuation because this is the upstream industry’s principal asset base. However, interest in mineral and royalty property valuation, while a much smaller part of the overall market, is growing rapidly because more investors recognize the benefits of this sub class. Black Stone Minerals announced (recently) a $340 million mineral and royalty acquisition that includes Permian interests. We note that the metrics associated with mineral and royalty properties are different than those applied to leasehold/working interests because of different revenue and cost economics per acre, differing control over the property, and the lower risk profile of minerals and royalties compared to working interests.
Compiled and Published by GIB KNIGHT
Gib Knight is a private oil and gas investor and consultant, providing clients advanced analytics and building innovative visual business intelligence solutions to visualize the results, across a broad spectrum of regulatory filings and production data in Oklahoma and Texas. He is the founder of OklahomaMinerals.com, an online resource designed for mineral owners in Oklahoma.