Tax Consequences on Investment Yardsticks in Oil Property Evaluations

Abstract

Abstract Most managements in today's oil industry use sophisticated methods in establishing yardsticks for investment analyses, one of the most common of which is the rate of return by the discounted cash flow (DCF). Although much has been written concerning this tool in investment decisions, information is lacking concerning the effects of federal income taxes on the results of this yardstick. Evaluation engineers are concerned primarily with establishing total gross reserves and the time-rate prediction, i.e., when those reserves will be recovered. Values are then placed on this recovery to determine the income-producing qualities of the property. Loan agencies look at the present worth at the current interest rate prior to federal income taxing for establishing production loan values. However, serious mistakes can be made easily by companies or individuals who desire to increase equity when they fail to consider the federal income tax effects on specific property apparisals for investment purposes. This article analyzes some of these effects as applied to corporations, although the same considerations apply to individuals. A comparison by the investor of DCF rate-of-return and other yardsticks prior to vs after an assumed income tax calculation shows the influence of this important consideration on these management tools. Effects of production payments on these taxes and investment profitabilities are also examined. Introduction Several factors must be considered, informally or formally, in making decisions concerning investment opportunities in the oil industry. These factors recently have become more and more sophisticated in that formal quantitative values have been given to these criteria. Although the rate of return as calculated by the DCF method is an important tool, it is shown in the literature that this factor is only a tool and that many other important factors must also be considered for each prospective investment. Most companies have established certain criteria for evaluating investment opportunities after carefully considering their history, investment needs, opportunities and financial structure. The income tax consequences on some of these yardsticks can be considerable and varied. Advantages or disadvantages of methods for establishing these criteria will not be discussed. Rather, it is assumed that the methods used in arriving at these criteria have been justified. As Campbell said, "To a large extent, arguing rate-of-return methods is about as pointless as arguing religion. It leads to little except conversation." For the purposes of this article it is assumed that outstanding engineers have predicted the gross oil to be recovered in the examples, and consequently there are few, if any, risk factors involved. Evaluation Reporting Techniques Most engineers, in appraising oil properties, report results in a format similar to that shown on Table 1, which is an example of recent property evaluation. Gross oil production is usually reported by years through at least the tenth year, and often up to 20 years. In this case a remaining life of 11 years was estimated. This is followed by the net oil to be accrued to the evaluated interest, followed by the gross revenue to be derived from this oil. Normally this gross revenue is based on current oil price. Operating costs are then deducted, followed by state and local taxes, to arrive at a figure sometimes called "net income" to be generated by the properties. This value, labeled "operating income" in this article, usually is shown discounted at some current discount rate; in this case, 6 percent was used to arrive at a present worth of operating income to be produced by the properties. Perhaps the most common means used in the past for arriving at the "fair market value" of a property was to take from 60 to 75 percent of this present worth, with two-thirds or 67 percent being the most commonly used value. In this case (discounting at 6 percent) these values would range from $167,000 to $209,000, with the two-thirds value being about $187,000. The term "fair market value" is used hesitantly because the author does not really know how to determine the fair market value of a property independently of discussions with the seller. A common definition of this value has been "the price agreed upon between a willing buyer and a willing setter, both being producers exclusively of oil and gas, each in possession of all known facts and both in the same tax bracket (corporations?), the property being purchased without the tax advantage of the oil payment method." JPT P. 1547ˆ