Changes

  | series  = Methods in Exploration

  | series  = Methods in Exploration

  | title  = Development Geology Reference Manual

  | title  = Development Geology Reference Manual

  | part    = Economics and risk asseement

  | part    = Economics and risk assessment

  | chapter = Economics of property acquisitions

  | chapter = Economics of property acquisitions

  | frompg  = 54

  | frompg  = 54

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.

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 the chapter on “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.

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.

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.

:<math> \mbox{Reserves remaining} = (\mbox{Annual production} - \mbox{Annual production rate at abandonment}) \div \mbox{Annual decline rate}</math>

:<math> \mbox{Reserves remaining} = (\mbox{Annual production} - \mbox{Annual production rate at abandonment}) \div \mbox{Annual decline rate}</math>

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<ref name=pt02r16>Thompson, R. S., Wright, J. D., 1985, Oil property evaluation, 2nd ed.: Golden, CO, Thompson-Wright Associates, 212 p.</ref>.

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.<ref name=pt02r16>Thompson, R. S., Wright, J. D., 1985, Oil property evaluation, 2nd ed.: Golden, CO, Thompson-Wright Associates, 212 p.</ref>

==Bid strategy==

==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:

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<ref name=pt02r2>Capen, E. C., Clapp, R. V., Campbell, W. M., 1971, Competitive bidding in high-risk situations: Journal of Petroleum Technology, v. 23, p. 641–653., 10., 2118/2993-PA</ref><ref name=pt02r11>Megill, R. E., 1984, An introduction to risk analysis, 2nd ed.: Tulsa, OK, PennWell Books, 274 p.</ref>. 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.

* 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.<ref name=pt02r2>Capen, E. C., Clapp, R. V., Campbell, W. M., 1971, Competitive bidding in high-risk situations: Journal of Petroleum Technology, v. 23, p. 641–653., 10., 2118/2993-PA</ref><ref name=pt02r11>Megill, R. E., 1984, An introduction to risk analysis, 2nd ed.: Tulsa, OK, PennWell Books, 274 p.</ref> 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.

* 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!”''

* 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!”''

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.

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 propeties, which minimize the winner's curse.

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

==References==

==References==