OT30336 - Capital Gains

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

Other ways of Risking

Applying a discount rate is not the only way of risking a discovery. The reserves can also be risked - using, say, 80% of the reserves in a DCF analysis. Alternatively the final result can be risked - carrying out a full DCF on a project which has, say, only a 60:40 chance of being developed and reducing the NPV by 40%. It is difficult to comment on whether any of the three ways is more valid than the other. When there is a choice between risking the reserves or risking the final result the latter may be appropriate if there are contemporary assumptions about development, opex and capex which depend on the full reserves being developed.

Weighted Average Cost of Capital (WACC)

A company may claim that the discount rate to be applied in arriving at the NPV should be the weighted average cost of capital for the company. This is an investment tool which is often used to determine the required rate of return for investors and shareholders - the cost of capital is calculated as a weighted average of the costs of equity and debt adjusted for leverage, risk and the effect on tax of the costs of debt. This is used as a financial hurdle rate by investors in the company, to reflect a perceived level of risk. The level of debt will impact returns achieved by investors. The essential point to note is that different capital structures will yield different WACCs.

In the case of a company, this would be inadequate for our purposes. We would be attempting to value the company using discount factors based upon investor risk assumption and capital structure, which will not necessarily reflect the underlying value or risk of the company’s assets. WACC also requires assumptions about investors’ expected returns in order to calculate a discount rate which is supposed to reflect the perceived risk, and it is not easy to gauge those assumptions. A proponent of this approach could argue that you should look at similar companies on the Stock Exchange and work out a discount accordingly. That there would be even a small number of upstream (only) companies of the right size with the necessary debt/equity ratios on the Stock Exchange would seem unlikely.

In the case of a project, another of the acknowledged difficulties about the WACC approach is the fact that the project being evaluated may well have a higher risk factor than the average of the company’s existing projects, and the method would not, therefore, give an acceptably accurate result. It is thus accepted that individual projects should be considered separately, and WACC would not be appropriate.

The Capital Asset Pricing Model (CAPM) will similarly inform an investor hurdle rate and may be deployed as an alternative and there are similar problems with use. This discount rate is essentially derived from the stock market and says nothing about the risks attaching to specific projects. It is necessary to take into account other considerations which would affect the investment decision and see whether those factors should be reflected in the discount rate.

Inspectors should, therefore, exercise caution in accepting the WACC (or CAPM) approach and consult the Oil Asset Valuation portfolio holder, currently Colin O’Donoghue.