Methods and Procedures for Estimating Fair-Market Value Of Petroleum Properties
Authors: Eggleston W.S. 
Published: December 2007

Fair-market value has come to have two meanings: one the legal term, and the other the economic or business term. Some authorities contend that fair-market value is exclusively a legal term. However, the terms has been adopted by petroleum economists and valuation engineers, and to them it means market value, trading value, or reasonable market price. While fair-market value or reasonable market price can never be a precise number it can be approximated within rather close limits. It is axiomatic that the market value of a property should be something less than the future net revenue, since the market value of production to be recovered some years hence has a lesser value than production recoverable in the immediate future. Before an exchange of properties, assets, obligations, or money can be effected, the appraisal engineer, the purchaser and the seller must reach substantial agreement as to the purchase price. The next step is that of compromise. To consummate a deal one party or the other may be required to assume a business risk of greater or lesser extent. Factors other than those that can be measured mathematically now come into play. Unnamed plus or minus considerations may exert more influence on the final price than strict adherence to mathematical formulas.

Introduction

A great deal of controversy, disagreement and debate surrounds the question of fair-market value. In some measure the trouble stems from an attempt to reconcile two different concepts: one the legal, and the other the economic or business concept. These approaches to value may vary considerably. Some authorities contend that fair-market value is exclusively a legal term, that its origin is in the law and there is its field. However, the term has been adopted by petroleum economists, bankers and valuation engineers, and to them it means market value, trading value, or reasonable market price. To clarify the issue these two concepts could be designated as fair-market value subscript L, meaning the legal term, and fair-market value subscript E, the engineering or economic term. Quoting from Montgomery's Federal Taxes : "The term ‘fair-market value’ has generally been defined by the courts as the price at which a seller willing, but not compelled to sell, and a buyer willing, but not compelled to buy, both having reasonable knowledge of all the material circumstances, will trade.... It has been facetiously suggested that the satisfactory settlement of a valuation dispute is marked primarily by equal dissatisfaction of both parties."While market value or reasonable market price of an oil-producing property can never be a precise number, it can be approximated within rather close limits by use of the engineering appraisal method. The Internal Revenue Service refers to this procedure as the "analytical appraisal by the present worth method."Methods of determining fair-market value of mineral properties, as listed by the IRS are as follows:

actual bona fide sale price; a bona fide offer to purchase; a bona fide offer of sale; the sale price of similar properties, similarly situated; market values of stock when same fairly and clearly represents the value of the property; royalties or rentals paid or received; analytical appraisals by the present-worth method; and valuations for purposes of state and local taxation and appraisals for court proceedings. Although the analytical appraisal by the present-worth method is far down on the list, it is generally given preferential consideration owing to the absence of most of the other factors in any particular case.

Future Net Revenue

The first step is to determine future net revenue. If the pertinent facts in regard to rates of production, reserves, income and costs are available, the determination of future net revenue is a relatively simple procedure, There is no good reason why estimates, made by equally qualified engineers in full possession of the facts, should differ materially. Material differences in estimates are due to lack of information, lack of experience and ability, carelessness, or bias.

JPT

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