Factors Beyond the Engineering Evaluation That Affect Fair-Market Values
Authors: Sherrod Gerald E. 
Published: December 2007

For many years fair-market-value determinations for oil properties were based on well established criteria of reserves and projected future revenues indicated by engineering analyses. Recently, prices paid for such properties have been higher than those calculated by these methods. Various factors not encompassed by the engineering appraisal affect these prices, including finding costs, refinery needs, refining and marketing profits, geographic location of properties, tax position of purchaser, rate of return sought, purchases by groups, management philosophy, type of purchase, incentive to investors and bid sales. Although the engineer appraiser may have no control over these factors, he should be aware of how they may influence the profit stream as calculated in the engineering analysis.

Introduction

Methods of estimating oil and gas reserves and their probable future revenue are fairly consistent throughout the petroleum engineering profession. Methods of determining the fair-market value of these reserves may vary, however, depending on the appraiser's, owner's, or purchaser's viewpoint. The outside appraiser-at-large may have access to all the available engineering data but may not be familiar with factors outside the engineering which can affect the value a purchaser would put on a property. Pride of ownership may cause the owner to put a premium on his sale price, but he also may not be aware of specific influences which affect the prospective purchaser's valuation. Within a prospective purchasing company, certain conditions or information may exist which make a property more or less valuable to them than to others. Certainly, on any property there are just so many units of hydrocarbons, regardless of who owns or acquires the property. However, there may be a wide difference in the manner and amount of reserves recovered and utilized to obtain the optimum profit. The purpose of this paper is to examine certain factors which influence values but which are usually outside the direct engineering appraisal. The engineering appraiser must keep abreast of constantly changing prices, costs, allowables, producing and finding techniques, markets and many other related factors. He must weigh these factors in light of the current situation and the possible future situations. The appraisers' tools are certain formulas and principles which are applied to the data. As in other types of appraisals, the oil valuator must use all the methods and approaches available on a specific problem; he should then weigh the different results before arriving at an answer. His judgment must be relied upon heavily in the final analysis. For many years fair-market-value determination has been based on a rather well defined analysis of the reserves and projected revenues derived from a detailed engineering evaluation. The purchases were usually negotiated at prices within range of the results of the engineering analysis. In some cases, however, the prices paid for properties have been in excess of any value that can be arrived at by applying the historic methods and yardsticks to the engineering data. It is evident that several factors outside the direct engineering analysis have been given stronger emphasis by the prospective purchasers. Some of the factors are due to the size, nature, make-up and character of the purchaser; others are due to the current economic, industry or money-market climates. The following paragraphs examine some of these factors which appear to be influencing market values.

Increased Finding Cost

An important factor that is putting a premium on reserve purchases is the increasing cost of finding and developing crude-oil or natural-gas reserves. These costs have increased to such an extent that buyers, in many instances, are finding it cheaper to buy than to develop reserves. A recent study by Hodges and Steele states: "The data all seem to support the hypothesis that the phenomenon of diminishing returns to exploratory drilling is being experienced with increasing severity from year to year, and has been operating more severely since about 1937–1939, the period of the lowest per-well and per-foot real cost of discovery". Farrier says the following. "In the past few years, an additional stimulus to purchasing developed reserves was the discovery by many companies that they were experiencing fairly substantial annual increases in the cost of finding and developing their own crude oil and natural gas reserves.

JPT

P. 1307^