Economics of property acquisitions

Development Geology Reference Manual
Series	Methods in Exploration
Part	Economics and risk assessment
Chapter	Economics of property acquisitions
Author	Peter R. Rose
Link	Web page
Store	AAPG Store

Estimating property value

The basic concepts and principles discussed in Part 2 are as applicable to evaluating producing properties for purchase as they are to oil and gas drilling ventures or development projects. As before, it is assumed that the data and estimates are well founded. For property acquisitions, however, even more importance is placed on rate, cost, and price estimates, as well as on process efficiencies if subsequent enhanced oil recovery and in-fill programs are contemplated. If the property is also perceived as having exploration potential, geological uncertainties (reserves and chance of success) must be considered as well for that component of the property value.

A common procedure for evaluating such proposed acquisitions is to establish the present value of the future cash flow stream. This should be based on very careful geotechnical and operational evaluation and discounted at the purchaser's corporate discount rate. Frequently, the next step is to recalculate the present value of the property at an artificial discount rate—perhaps 50 to 100% higher— and attempt to acquire the property for that value. This is an example of the pragmatic use of discounted cash flow analysis and the discount rate as a “risking measure.” The logic is that if the property is worth, say, cost::2 USD million discounted at 10% and cost::1 USD million discounted at 18%, then purchase at about the cost::1 USD million figure should give an adequate “cushion” to protect the buyer from unanticipated negative surprises in the future, while still returning at least 10% on the purchase price. Although such methodology is commonly employed, it should be recognized as pragmatic in the extreme, inasmuch as no relationship exists between the discount rate and chance of commercial success.

An alternative approach is to use the expected value concept. After making very careful probabilistic assessments of remaining reserves, rates, costs, and prices, project present value is estimated at the firm's chosen discount rate at probabilistic levels (P_90%, P_50% and P_10%). Then the chance of minimal acceptable commercial profitability is used to define the chance of commercial success and the chance of failure (as described in Expected value and chance of success). This allows determination of the expected value of the proposed acquisition and facilitates equitable comparison and capital allocation among prospects that are competing for consideration by the firm. Be sure to include the purchase price in the expected value calculations.

This approach also allows the decision maker to assess such proposed acquisitions in terms of the chance of returning various profit levels (and also various loss levels). Finally, use of different possible purchase prices in the expected value calculation is useful in identifying the appropriate bid amount.

Remaining reserves are calculated as follows:

${\mbox{Reserves remaining}}={\frac {({\mbox{Annual production}}-{\mbox{Annual production rate at abandonment}})}{\mbox{Annual decline rate}}}$

This equation is a “quick and dirty” method only, allowing rapid estimation of remaining reserves of a producing well, lease, or field, and it can be useful in early assessments and negotiations. A comprehensive coverage of production forecasting and estimating reserves from production data is presented by Thompson and Wright.

Bid strategy

Sales of producing properties are often well advertised, attracting several potential purchasers, and are commonly carried out by sealed bidding. It is important to recognize that sealed bid sales of oil and gas properties contain several inherent pitfalls:

• Because reserves and producing rates are lognormally distributed, independent present value estimates of the same property will also tend to be lognormally distributed. This phenomenon is well documented for offshore lease sales. Accordingly, there will tend to be a larger numerical differential between the first and second bids than between the lowest and second-lowest bids. This leads naturally to large overbids or “leaving money on the table” as an inherent byproduct of the mathematics.
• Geotechnical forecasts of reserves, producing rates, and so on are estimates made under uncertainty. Hence, both overestimates as well as underestimates are likely to occur in a group of independent estimates of the same property. Final bid levels are most influenced by estimates of reserves and rates. In sealed bidding, the property goes to the highest bidder. Accordingly, there is a marked tendency for winners of sealed bid sales to have overestimated the present value of the property— usually by overestimating reserves or rates. This is called the winner's curse. Moreover, because of lognormality, the amount of money left on the table by the winner is frequently substantial. This pattern is most significant for exploration bidding, but it should still be taken into account in sealed bidding for producing properties.
• The result is commonly that acquisitions are substantially less profitable than the purchaser has anticipated. And when the previously discussed unanticipated geotechnical, process, and economic risks are factored in, the danger is doubled. Technical assessors must never forget that the central goal is to make a sound profit on the purchase. The appropriate mind set to operate from is, “If we cannot acquire this property at our price, we do not want it!”

How can the prudent purchaser guard against overbidding? Megill shows that the average overbid in offshore continental shelf sales is about twice the size of the second bid, suggesting that a 50% reduction of calculated expected present value is an appropriate reduction. (Here it is important to note that the term expected present value as used here includes all geotechnical costs, but not the purchase price, which is what we are attempting to fix.) Capen et al. go farther, suggesting that for exploratory ventures having great uncertainty, sealed bonus bids should be reduced to 35% to 20% of expected present value, depending on the anticipated numbers of participants.

However, less uncertainty ordinarily attends producing properties, so perhaps such sealed bids could be reduced by 25% to 50%. Table 1 shows sample calculations and company bid levels determined by two methods: (1) a 50% reduction of the expected value (not including bid) versus (2) conventional procedures utilizing present values at artificially elevated discount rates, as described at the beginning of this chapter.

Table 1 Comparison of calculated bid levels

Assumptions	Corporate discount rate = 10%
	Minimum commercial PV @ 10% = cost::1,000,000 USD
	Chance of success (achieve minimum commercial PV or more) = 80%
	Mean present value of all success scenarios @ 10% = cost::2,000,000 USD
	Chance of failure (achieve less than minimum commercial PV) = 20%
	Mean present value of all failure scenarios @ 10% = –cost::400,000 USD
	Mean present value of all success scenarios @ 18% = cost::1,000,000 USD
	Mean present value of all success scenarios @ 20% = cost::800,000 USD
Expected present value calculation	0.8(cost::2,000,000 USD) + 0.2(–cost::400,000 USD) = +cost::1,520,000 USD = EPV10%
Bid strategy method	cost::1,520,000 USD × 0.5 = cost::760,000 USD = Recommended bid
Recalculation of expected present value (including recommended bid)	0.8(cost::2,000,000 USD – cost::760,000 USD) + 0.2(–cost::400,000 USD – cost::760,000 USD) = cost::760,000 USD = EPV10%
Conventional method (using PV as a risking measure)	PV@ 10% = cost::2,000,000 USD
	PV @ 18% = cost::1,000,000 USD = conventional bid to allow for risk = cost::1,000,000 USD
	PV @ 20% = cost::800,000 USD = more prudent bid to guard against overestimating = cost::800,000 USD

The problem with the latter approach is that it fails to protect against substantial overestimates, and thus overbids, which are by no means uncommon! Accordingly, if some form of the artificial present value method is used and there is significant uncertainty as to ultimate recoverable reserves or if serious financial consequences would arise from a substantial overestimate, it is recommended that the artificially elevated discount rate can be as much as two times higher then the firm's actual corporate discount rate (Table 1).

A common reaction to these recommended large reductions in bid levels is, “We will never win a property with such low bids.” But abundant experience demonstrates that this is simply not correct, assuming multiple bidding opportunities and exposures. Also, the reader is reminded that the objective is not just to acquire producing properties; the goal is to make a profit! It is interesting to note that the prevailing opinions among recent buyers and sellers of producing properties sold by sealed bids is that the sellers are most often more satisfied than the buyers.

Perhaps this explains the proliferation since 1990 of auction sales of U.S. producing properties, which minimize the winner's curse.

See also

• Risk: expected value and chance of success
• Economics: time value of money
• Risk: dealing with risk aversion
• Economics: fundamental equations for oil and gas property evaluation
• Economics: key parameters
• Taxes
• Uncertainties impacting reserves, revenue, and costs
• Cash flow model

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