OT30334 - Capital Gains

Valuation of Oil Assets (including shares). Methodology. Discount Rates & Risking.

General

The discount rate will have a significant effect on NPVs. Selection of rate can be a major source of dispute. The discount rate tends to focus on the monetary risk factors, but there are other risks that need to be considered and factored in. What degree of certainty is there on the level of reserves? If development is contingent on events which are not certain does that uncertainty need to be factored in? Are there features about the reservoir which cast doubt on reserve recovery? One way or another all risks and uncertainties need to be accounted for in the discount factor, the risking of reserves or in some other way (see OT30336).

Discount Rates

Discount rates can be real or nominal (nominal is real + inflation i.e. if the real rate is 10% and inflation is 8% the nominal rate will be 18.8%). In theory the inflation element in a cash flow should not matter as it should be stripped out when the discount rate is applied but you should note:

• in practice it may matter because the inflation element in the nominal rate may not match the inflation rate applied to expenditure and income; and
• you should avoid constructing DCF analyses on the basis of a real rate with no inflation. This can impact on the tax calculation and the offset of tax losses brought forward