Discount Rates, Cost of Capital, and Property Acquisition Evaluations

Abstract

Abstract The purpose of this paper is to examine the role of the discount rate in determining the fair market value of a producing oil and gas property; to assess the validity of a discount rate based on a derived source and on an observed or market source, and to evaluate the relationship between discount rates obtained from these two sources. The derivation of a discount rate based on a Cost of Capital approach is compared to the observed effective rate-of-return obtained from analysis of actual producing property acquisitions to (1) determine if a rational relationship occurs between discount rates obtained from the two methods, and (2) how the discount rates obtained from the two methods may reflect changes in the oil and gas industry. The use of derived and observed discount rates in FMV analysis is examined and discussed, particularly as it applies to property acquisitions. The source of the study reported by this paper is an annual review and analysis of oil and gas property transactions in California which is done for the Western Oil and Gas Association (WOGA) and the California Independent Producers Association (CIPA) and which is generally referred to as the "WOGA Study."(1) The WOGA study attempts to define market economic parameters used in the acquisition of producing properties in California. The study examines several economic factors, including price/cost projections, but particular attention is given to the effective discount rate related to the determination of Fair Market Value. This market data forms the basis for industry recommendations to the county tax assessors regarding the methods and parameters to be used in appraising oil and gas properties for ad valorem taxes. The objective of industry and assessors is to define a method, and the economic parameters necessary, to determine the present value and, more to the point, the Fair Market Value (FMV) of an oil and gas producing property. The same concern for proper evaluation methods and appropriate economic functions is thought to exist throughout the industry where operators, interest owners, financiers, and investors need to determine the market values of producing properties. The study concludes that: The pre-tax cost of capital of a company or industry group provides a reasonable "base" discount rate for evaluation of producing properties. The effective FMV ROR on actual acquisitions consistently exceeds pre-tax cost of capital by several percentage points. The divergence between observed ROR and cost of capital appears to vary depending, at least in part, on the perceived risk in the property appraisal. Risk adjustments on a project or other basis, if identifiable, are not quantifiable from the data available. The Cost of Capital for the oil and gas industry, from a sample group, averaged 19–20% for 1983–1985 declining to 14.9% in 1987. The market discount rate from actual sales of properties for the 1983–1987 period, ranged between 26–28% which provided a reasonable and safe return above the cost of capital.