The Relationship Between Rate of Return, Payout and Ultimate Return in Oil and Gas Properties

Abstract

Abstract Rate of return is being recognized more widely as a measure of the attractiveness or profitability of investments in oil and gas properties. "Rate of return" is that interest rate which results in the discounted present worth of future net income being equal to the initial investment in the property. It is usually calculated by means of trial-and-error. In this paper a factor, called "composite decline-discount factor," is introduced which eliminates trial-and-error for properties having constant percentage decline. Formulas have been derived and charts plotted showing the relationships between rate of return, payout, ultimate return, market value expressed as a fraction of discounted present worth, and "average annual rate of return". Rate of return on equity capital in oil payment transactions is also investigated. Introduction The evaluation of a proposed drilling prospect or purchase of a producing property does not end with a report giving its cost and estimated net income by years. Management must have some criterion or yardstick for judging the attractiveness or profitability of the project. Probably the most common criteria are payout and ratio of ultimate return to investment. Their disadvantage is that they represent two independent yardsticks and do not give a single, unique answer to the question, "How attractive is this project?" For example, which is more desirable, a property having a three-year payout and an ultimate return-investment ratio of 2 to 1, or one having a five-year payout and an ultimate return-investment ratio of 3.5 to 1? To answer this type of question, various methods for measuring the earning power of invested capital have been applied to oil and gas properties. One of particular merit is the rate of return method, also called the internal rate of return method, the discounted cash flow method, or the investor's method. Rate of return is that interest rate which results in the discounted present worth of future net income being equal to the initial investment in the property.