Market Discount Factors for Fully Developed, Declining Production

Abstract

Listen

Translate article

Summary Every active market transaction provides a signal of a discount factor. Economic fundamentals show how that signal can be discerned from actual markettransactions for fully developed properties producing under decline. Introduction Consider, as a homogeneous class, fully developed oil properties producingunder exponential decline. Such properties involve only proved reserves thathave already been developed. (The recently approved SPE reserve definitionsprovide for proved reserves that may or may not yet be developed. Fullydeveloped producing properties are only one of many classes of assets that mayexist in the investment portfolio of an oil company. Compared with the otherclasses, frilly developed producing properties should have minimal risks anduncertainties. Fair Market Value and the Discount Factor. The legal precedents definingfair market value require strict hierarchical adherence to actual transactionsin the market for the same (or same class of) assets. Every transaction in anactive market is a signal of value. Each transaction occurs when a buyer and aseller stop haggling and agree on a price. Each agreement is also a signal of adiscount factor in the market for that class of asset. Sinha and Poole recentlyreviewed the methodologies that define discount factors that individual actorsin the market may use. The underlying notion is simple, sound, and global. Atiller of soil must reap more crops than seeds planted to be successful. Thus, an asset must return more money than the cost of its "seed" money, expressed with a discount factor. Sinha and Poole note, however, thatapplication of the methodologies "is not precise," leading to actualdiscount factor selections "based upon experience and judgment." In1972, Silbergh and Brons concluded similarly that ". . the cost of moneycannot be measured precisely anyway, even if one were sure of the preciselyanyway, even if one were sure of the theory. Miller and Vasquez articulate whythe theory's application is difficult and may be impossible. They note that therelevant measure is the marginal cost of money for the assets in question. Themarginal cost of money is not the same as an effective or "average"cost of money for the aggregation of investments that may make up an oilcompany. The effective cost of money can be measured. Adelman surveyed oilcompanies' discount factors. These may reflect the effective cost of money forthe aggregate of a company's investments, but not the marginal cost of money. Miller and Vasquez correctly observe that the marginal cost of money depends on"the cost of the last increment of capital obtained." Thus, themarginal cost of money depends intrinsically on the nature of the asset inquestion and the market's view of that asset. The market expresses its view ofany asset (or class of assets) by signaling a discount factor, the marginalcost of money that the market is charging. Thus, market discount factors arespecific to a class of asset, and any study of the market for any class ofassets necessarily involves an examination of the discount factors displayed inthe market for such assets. This study first surveys discount factors used foroil and gas assets for more than 3 decades. Then, from economic fundamentals, the mathematical relationships connecting market values and discount factorsare constructed for fully developed producing properties. Price and costprojections affect properties. Price and cost projections affect market value. Various rules of thumb for this class of asset are examined. The economicfundamentals provide a uniform rationale for these rules of thumb and showtheir burdens. Active markets are, perhaps by their very nature, chaotic inappearance, yielding a profusion of signals. Yet, any particular, profusion ofsignals. Yet, any particular, reasonably homogeneous class of assets shoulddisplay a coherent pattern. Over 3 decades, some rather stable inflation- andescalation-adjusted market discount factors, in real terms, are found for fullydeveloped producing properties. A Survey of Market Discount Factors Table 1 presents a compendium of discount factors for oil and gas assetsdrawn from more than 30 years of technical literature. That the discountfactors range from 5 to 33 % should not be a surprise. The range does notnecessarily imply some underlying shift or disagreement. JPT P. 350