OT30331 - Capital Gains

Valuation of Oil Assets (including shares). Methodology. Fields. Discounted Cash Flow. Process.

The DCF is based on the fundamental theory of value. This states that the value of a financial asset (but not necessarily its open market value) is the sum of the present values of future cash flows stemming from the ownership. It is most commonly used where future income can be estimated with some degree of certainty. As such the OTO, accepts it is appropriate for fields and some prospects, but not for exploration acreage.

DCFs are used by people with different interests e.g. bankers, accountants, oil analysts, economists, petroleum engineers, tax planners and the terms on which the model is drawn up and the consequential value will reflect their different concerns.

Contemporary DCFs should be considered critically – for example, are they based on overly optimistic or pessimistic assumptions? The context is very important and it is necessary to consider for whom the cash flows were prepared. Even if a DCF has a particular bias it may still yield useful information.

It is very common to value a field on a stand-alone basis and it may well be necessary to make further adjustments, such as consolidating DCFs for a company valuation, or to take account of off-setting exploration expenditure or tax overhang. It will also be necessary to decide whether the resulting figure, the asset value, is also the open market value(see OT30332+).

Valuing the asset using a DCF has two stages:

• a production forecast; and
• a prediction of the financial performance of the asset, which includes the expected future product prices and expenses.

The production forecast is a prediction of the amounts of the future production of oil and/or other hydrocarbons (production streams) from the asset projected over time – typically 20 to 25 years.

The DCF analysis of those expected production streams determines the present value of the net cash that will be generated in the future from the production and sale of the forecasted amounts of oil less the operating expenses, royalties, and taxes incurred as the production streams are produced. The resulting cash flow stream is discounted to a reference date to arrive at the net present value (NPV).