BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE - PDF document

BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE VALUING PUD RESERVES:APPLICATION OF REALby John McCormack,Stern Stewart & Co., andGordon Sick, to adopt discounted cash flow methods in valuing assets andwell understood by managers and generally provide accurate valuations ofdeveloped hydrocarbon reserves. Unfortunately, DCF techniques systematicallymanagement opportunities.Managers in the oil industry have long been aware that the market valueof individual oil properties, not to mention entire E&P companies, is usually This is particularly truevalue for some undefinable “upside” associated with undeveloped reserves.than traditional DCF analysis, real option models provide a far more completeowners of PUDs have the right, but not the obligation, to develop those reservessome additional option or “volatility” value. There is a sound economic reasonto assess undeveloped reserves at more than their DCF value, and real options T*Computational routines for this analysis were developed by Dan Calistrate.1. See, for example, James L. Paddock, Daniel R. Siegel and James L. Smith, “Option Valuation of Claims on Real Assets:The Case of Offshore Petroleum Leases,” Quarterly Journal of Economics, V. 103 #3, (1988) 9VOLUME 13 NUMBER 4 WINTER 2001 A simple example illustrates this option value.correctly, that developing this reserve now wouldZero NPV really becomes the lower bound of thelike a PUD even if immediate development wouldvolumes to expect from a PUD and can see therelevant futures prices in the marketplace. Thisthe cost of development, which corresponds to thecorresponds to the dividends paid on a share offluctuate depending upon other factors. This fluctua-option such as a PUD. Among the most importantare different from spot prices and lie along a Call option on shares of stockProven Undeveloped Reserve (PUD)Underlying share priceDCF value of reserve when developedStrike priceCapital Exp. needed to develop reserveTime to expirationTime remaining on mineral leaseDividendValue decay resulting from waitingTime value of money (Treasury rate)Time value of money (Treasury rate)Volatility of share priceVolatility of developed reserve valueIn-the-money value (share price minusNPV of project futures market for oil was in “backwardation,”month were higher than for delivery further in theearly 1998, on the other hand, oil futures prices for2. The cash flows expected from the developmentof a PUD change over time not only because pricesto produce will also vary. Generally, productionmeans that the economic life of an oil field is at leastsomewhat “front-loaded.” The more front-loaded ismean-reversion of petroleum prices causes a declinemarket price. Otherwise, arbitrageurs would be ableing to geographical delivery point. For example,futures contract is a given. However, the strike priceof a PUD—that is, the expected present value ofthe developed project. PUD owners, of course, risewith an increase in hydrocarbon prices. At the samevalue for the PUD. The stronger the correlation5. The value of a financial option is driven in partby the expected volatility of the underlying stockfor a specific delivery month). But the volatility ofthe same as the volatility of either spot prices orof a particular futures contract. Like hydrocarbonthe expected volatility of prices all along theate ownership of the underlying assets. By contrast,value of the option relative to the underlying. Thisdrilling costs are correlated with the stock marketindex, a risk premium must be incorporated in the 11VOLUME 13 NUMBER 4 WINTER 2001 curves for oil and gas from the listed futures andby applying a mean-reverting random process to the(or reverts) towards a long-term mean price. Anythe long-term price. If the spot price is above thelong-term mean, then the futures price curve de- If the spot pricea random price deviation from the long-term mean.parameters can be established by analysts on a case-both hydrocarbon prices and other economic factorssuch as inflation. The model allows XYZ to assumepositively correlated with hydrocarbon prices overinput appropriate “time to build” periods betweenthe decision to drill a well and the start of production.rather than on a share of stock with a current market,the model allows the user to input a risk premium towas characterized in terms of a premium above therisk-free rate of return. However, the risk premiumcommand a risk premium. The present value ofMost of the inputs to the model depend onA team of analysts from XYZ set about examin-place in a particular region in the continental U.S. producing formation, but this requires precise engi-rose and fell nearly in tandem with commoditycomponent of value in PUDs would be quite modest.prepared to conclude that there is no relationshipat all, we do feel confident in saying that therates often rise after commodity prices have in-creased. And such rig rates often remain relativelythere are unpublished discounts from daily rig ratesthat appear only after the drilling is complete andthan others and require more expensive rigs. Differ-ent parts of an area may be drilled at different timesthat no premium on top of the risk-free rate wasBecause the NPV was positive, traditional theoryand practice held that XYZ should immediately drillreal option, however, then some amount of optionvalue would be surrendered through exercise of theWe assumed that $610,000 of the $920,000 ofwere taken from NYMEX data at the end of 1999calculated the total economic value of that drillingother $176,000 represented volatility value. This 13VOLUME 13 NUMBER 4 WINTER 2001 These reserves have both DCF and real optionof E&P companies is greater than can be accountedfor through DCF means, implying that the marketers’ wealth. It is almost certain that an opportunitycalculation is not made with the benefit of hindsight.were observable in the commodity futures andoptions markets during the fourth quarter of 1999!board of director level.the industry. Engineers, in particular, like to be ableto point to tangible, physical evidence of their labors.very real economically. Companies need to able totions. Every PUD has embedded within it somesort of real option. This value can be increased inothers is a source of wealth creation. Companiesby hydrocarbon price volatility generally. Thevalue added through this kind of flexibility can besystem that recognizes them. A forward-lookingand volumetric production will be the right thing tomanagers for choosing to delay. Few companiesvalue. Incorporating real option valuation methods