Which Fair-Market-Value Method Should You Use? (includes associated papers 20323 and 20382 and 20392 and 20987 and 21304 and 21305 )
Authors: Garb Forrest A. 
Published: December 2007

Distinguished Author Series articles are general, descriptiverepresentations that summarize the state of the art in an area of technology bydescribing recent developments for readers who are not specialists in thetopics discussed. Written by individuals recognized as experts in the area, these articles provide key references to more definitive work and presentspecific details only to illustrate the technology. Purpose: to informthe general readership of recent advances in various areas of petroleumengineering.

Fair-market-value (FMV) determination is now used not only to set a purchaseprice but also to determine the best investment. Various methods fordetermining an FMV have been used, all in attempts to protect a purchaseragainst the uncertainties that might render an acquisition imprudent. Thispaper reviews frequently used FMV guidelines and presents a method for theirsimultaneous use to evaluate a hydrocarbon-producing property.

Introduction

The current acquisitional tendencies of the U.S. oil industry have increasedthe importance of determining the best investment among many options. FMVdetermination is now used not only to set a price, but also to select theinvestment. The FMV for a producing property is not a unique value derived bysolving an equation; rather, it is a subjective estimate reflecting theexpectations of the buyer and the seller at the time of trade. Any change inthe economic outlook will likely change the estimated FMV, but not necessarilythe method used to derive it. The various methods used to estimate the FMVnever yield exactly the same value, but they usually establish a range. Becausean FMV may be required to estimate a collateral value for a bank loan, tosettle litigation, or to establish tax liability, the appraiser isusuallequired to establish a single value estimate rather than a range. Theappraiser estimating the FMV, therefore, must have a good knowledge of thevarious FMV guidelines used in the industry and must know their strengths andweaknesses to narrow the range.

Definition

There have been several definitions of FMV, but the one cited mostfrequently in the petroleum industry is "the amount a willing buyer will pay awilling seller, with the property or interest exposed to the market for areasonable period, neither the buyer nor the seller being under a compulsion tobuy or to sell, both being competent and having reasonable knowledge of thefacts." Unfortunately, this ideal situation rarely, if ever, exists. The sellerusually is under pressure to liquidate some asset. There may be a cash needwithin the company, or a more attractive investment opportunity may arise. Inprivate companies, the proprietor may reach retirement age. The acquisitionsvice president of the buying company may need to purchase something to confirmthe importance of his job. The definition also assumes that the buyer isknowledgeable. The seller of the property, who is associated with theoperations of the subject property, is usually in a better position to know thepositive and negative aspects of the property. The negative may not bepresented to the prospective purchasers, while the positive certainly will be. Of course, there are times when the property may have greater value to thepurchaser than to the seller. This sometimes occurs when the purchaser is theend-user of the oil or gas and is buying the production to ensure a feedstockor an energy source for day-to-day operations. Steel mills, breweries, andglass plants have purchased gas-producing properties to guarantee a source ofeconomical energy during potential periods of fuel shortage. Confusionsometimes exists about the terms present worth (PW) and FMV. Too often, non-petroleum-industry personnel think that the PW of a hydrocarbon-producingproperty is the FMV, or the value at which the property would change hands. This notion is understandable because, when we speak of almost any item we own(e.g., an automobile). its PW is its price. The difference. of course, is thatmost items we buy or sell are not incomeproducing. The meaning of PW changeswhen we speak of values that result from income to be received in the future. In this instance, PW is merely the value today of those future revenues.

Methods for Determining FMV

The various methods for determining FMV fall into four generalcategories:comparative sales, rule-of-thumb. income forecast, and replacementcost.

All the methods attempt to establish a fair price for a property thatprotects the buyer against all foreseeable business uncertainties and risks. These uncertainties, which may render the purchase imprudent, includetechnological, economic, and political concerns. The technologicaluncertainties include the possibility that the reserves might not be recoveredin the amounts or at the rates forecast.