Determination of Discount Rate Range for Petroleum and Hard Mineral Properties
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Determination of 2002 Discount Rate Range
for Petroleum and Hard Mineral Properties

The Texas Comptroller of Public Accounts conducts a statewide annual Property Value Study (PVS) that includes petroleum and hard mineral property appraisals. These appraisals are conducted using the methods and procedures outlined in the Manual for Discounting Oil and Gas Income, required by Texas House Bill 925, 73rd Legislature (codified as Section 23.175, Property Tax Code).

As part of its study, the Texas Comptroller’s Property Tax Division (PTD) calculates a range of discount rates to discount the future income of oil and gas properties. For the 2002 statewide study, PTD will use a range of 17.26 percent to 21.97 percent.

The remainder of this report is devoted to summarizing this year’s appraisal methodology for discount rate range determination. For more detailed information, please contact Doug Kubecka at (800) 252-9121, extension 5-9824 or (512) 305-9824, email <doug.kubecka@cpa.state.tx.us>, Connie Shaffer at (800) 252-9121, extension 6-6967 or (512) 936-6967, email <connie.shaffer@cpa.state.tx.us>, or Clint Simmons at (800) 252-9121, extension 3-5288 or (512) 463-5288, email <clinton.simmons@cpa.state.tx.us>.

Petroleum and Hard Minerals Appraisal

A primary economic parameter used to appraise oil, gas, and hard minerals is the discount rate used to convert the future value of an income stream to a present day value. The discount factor used by PTD to appraise properties includes the base discount rate, risk adjustments, and the ad valorem tax rate.

The process of discounting converts the value of cash received in the future to the current price investors would pay for the right to receive the income. This appraisal method is called the “income approach.” Most appraisers, including PTD staff, use the income approach to appraise mineral properties in Texas.

PTD, like a typical investor, will account for expected increases or decreases in product prices when appraising oil and gas property. Texas Comptroller’s Revenue Estimating Division (HB 925) prepares an annual oil and gas price escalation forecast. Appraisal districts may not exceed the forecast in valuing petroleum and mineral properties for ad valorem tax purposes.

Discount Rate Range Determination

There are three generally accepted methods for estimating a discount rate: weighted average cost of capital, market surveys, and oil and gas sales analyses. They are defined in the following paragraphs. For simplicity, the market survey and sales methods are presented together.

The Weighted Average Cost of Capital (WACC) Method

PTD reviews a group of petroleum companies doing business in Texas by grouping them as either an integrated petroleum company or a non-integrated petroleum company. Integrated companies conduct operations from the reservoir to the gasoline pump, while non-integrated companies conduct operations from the reservoir to the pipeline. These oil companies are listed on either the New York Stock Exchange (NYSE) or the Over The Counter (OTC) market.

PTD conducts an annual study of a range of discount rates based on the weighted average cost of capital of integrated and non-integrated petroleum companies operating in Texas. The results of the WACC’s calculations are presented in the next page.

Table 1: Integrated Petroleum Companies’
Financial Information Used for WACC Method

Company Name Total
Capital
$ 		Total
Equity
$ 		Total
Preferred
Stock
$ 		Total
Debt
$ 		Equity
% of
Capital
$ 		Preferred
Stock
% of
Capital 		Debt
% of
Capital 		Beta
Factor 		After
Income
Tax
Cost of
Equity, % 		Before
Income
Tax
Cost of
Equity, % 		Cost of
Preferred
Stock
% 		Cost of
Debt
% 		Before
Income
Tax
WACC
%
Amerada Hess Corporation 9,547,312,500 5,547,312,500 0 4,000,000,000 58.10 0.00 41.90 0.49 9.53 14.66 0.00 6.52 11.25
Anadarko Petroleum Corporation 17,395,515,000 14,320,515,000 0 3,075,000,000 82.32 0.00 17.68 0.70 11.00 16.92 0.00 6.84 15.14
Apache Corporation 7,718,706,569 6,838,706,569 0 880,000,000 88.60 0.00 11.40 0.60 10.30 15.85 0.00 7.09 14.85
Burlington Resources, Inc. 10,404,223,723 9,054,223,723 0 1,350,000,000 87.02 0.00 12.98 0.73 11.21 17.25 0.00 7.50 15.98
ChevronTexaco Corporation 100,412,650,691 95,633,650,691 0 4,779,000,000 95.24 0.00 4.76 0.56 10.02 15.42 0.00 5.89 14.96
Devon Energy Corporation 5,364,909,700 4,729,909,700 10,000,000 625,000,000 88.16 0.19 11.65 0.68 10.86 16.71 6.67 7.42 15.61
Exxon Mobil Corporation 307,061,000,000 306,147,000,000 0 914,000,000 99.70 0.00 0.30 0.36 8.62 13.26 0.00 6.25 13.24
Kerr-McGee Corporation 7,540,156,084 5,490,156,084 0 2,050,000,000 72.81 0.00 27.19 0.89 12.33 18.97 0.00 6.76 15.65
Marathon Oil Corporation 11,481,851,470 9,281,851,470 0 2,200,000,000 80.84 0.00 19.16 0.87 12.19 18.75 0.00 6.47 16.40
Occidental Petroleum Corporation 12,748,258,137 9,925,558,137 0 2,822,700,000 77.86 0.00 22.14 0.59 10.23 15.74 0.00 6.64 13.72
Phillips Petroleum Company 31,129,403,544 24,689,403,544 0 6,440,000,000 79.31 0.00 20.69 0.63 10.51 16.17 0.00 6.57 14.18
TOTAL $520,803,987,417 $491,658,287,417 $10,000,000 $29,135,700,000 909.98 0.19 189.83 7.10 116.80 179.69 6.67 73.94 160.99
ENTRIES         11 1 11 11 11 11 1 11 11
AVERAGE         82.73 0.19 17.26 0.65 10.62 16.34 6.67 6.72 14.64
STANDARD DEVIATION         11.27 0.06 11.28 0.15 1.08 1.67 2.01 0.48 1.47

The mean WACC was 14.64 percent with a standard deviation of 1.47 percent for the 11 companies.


Table 2: Non-Integrated Petroleum Companies’
Financial Information Used for WACC Method

Company Name Total
Capital
$ 		Total
Equity
$ 		Total
Preferred
Stock
$ 		Total
Debt
$ 		Equity
% of
Capital
$ 		Preferred
Stock
% of
Capital 		Debt
% of
Capital 		Beta
Factor 		After
Income
Tax
Cost of
Equity, % 		Before
Income
Tax
Cost of
Equity, % 		Cost of
Preferred
Stock
% 		Cost of
Debt
% 		Before
Income
Tax
WACC
%
Cabot Oil & Gas Corp. 922,040,053 760,040,053 0 162,000,000 82.43 0.00 17.57 0.74 11.28 17.35 0.00 7.46 15.62
Chesapeake Energy Corporation 1,399,072,674 1,088,947,674 10,125,000 300,000,000 77.83 0.72 21.44 0.56 10.02 15.42 6.75 8.51 13.87
Forest Oil Corporation 1,418,661,640 1,318,661,640 0 100,000,000 92.95 0.00 7.05 0.80 11.70 18.00 0.00 8.99 17.36
Houston Exploration Company, The 1,122,955,263 1,022,955,263 0 100,000,000 91.09 0.00 8.91 0.85 12.05 18.54 0.00 8.36 17.63
Noble Affiliates, Incorporated 2,461,734,717 2,011,734,717 0 450,000,000 81.72 0.00 18.28 0.84 11.98 18.43 0.00 7.98 16.52
Ocean Energy Incorporation 4,661,341,251 3,358,091,251 3,250,000 1,300,000,000 72.04 0.07 27.89 0.74 11.28 17.35 6.50 7.42 14.58
Pioneer Natural Resources Company 2,901,814,948 2,001,814,948 0 900,000,000 68.98 0.00 31.02 0.90 12.40 19.08 0.00 8.53 15.81
Pogo Producing Company 1,660,048,870 1,410,048,870 0 250,000,000 84.94 0.00 15.06 1.00 13.10 20.15 0.00 8.69 18.43
Questar Corp. 2,192,161,345 2,042,161,345 0 150,000,000 93.16 0.00 6.84 0.53 9.81 15.09 0.00 7.92 14.60
Southwestern Energy Company 389,953,707 264,953,707 0 125,000,000 67.94 0.00 32.06 0.29 9.81 12.51 0.00 6.39 10.55
Vintage Petroleum, Inc. 1,286,525,103 911,525,103 0 375,000,000 70.85 0.00 29.15 1.14 14.08 21.66 0.00 8.55 17.84
XTO Energy, Inc. 2,466,022,863 2,166,022,863 0 300,000,000 87.83 0.00 12.17 0.84 11.98 18.43 0.00 8.16 17.18
TOTAL $20,416,309,572 $18,356,957,435 $13,375,000 $4,512,000,000 971.79 0.79 227.42 9.23 139.49 212.02 13.25 96.96 189.98
ENTRIES         12 2 12 12 12 12 2 12 12
AVERAGE         80.98 0.40 18.95 0.77 11.62 17.67 6.63 8.08 15.83
STANDARD DEVIATION         10.05 0.23 10.03 0.25 1.43 2.67 2.79 0.76 2.39

The mean WACC was 15.83 percent with a standard deviation of 2.39 percent for 12 companies.

Combined Results of the Integrated and Non-Integrated Petroleum Companies

Considering both groups of companies, the overall mean WACC for the 23 companies was 15.26 percent with a standard deviation of 1.95 percent.

The Market Surveys and Oil and Gas Sales Studies Method

The Western States Petroleum Association has commissioned a study for a number of years concerning fully disclosed oil and gas lease sales information in California. This study is conducted and published annually by Richard J. Miller & Associates.

The Society of Petroleum Evaluation Engineers’ Twenty-First Annual Survey of Economic Parameters Used in Property Evaluation in June 2002 is an annual opinion poll. The responses from petroleum producing executives, industry consultants and energy banks in the realm of property acquisition and divestiture offer insight into the discount rates used to analyze properties in the market.

Reconciling Results

PTD established the upper end of a range of discount rates by reconciling data from an annual petroleum property sales study compiled outside the state, an annual petroleum industry survey, and the Comptroller’s annual property value study in Texas. Similarities were evident in comparing the statistical results of these surveys and studies; however, the differences highlight the contrasting views in the market.

The following table summarizes the results from these surveys.

Table 3: Summary of Findings for Three Annual Sales, Survey,
and Value Study for Year 2001 PVS

Study Author Discount Rate
Composite 		Standard
Deviation 		Discount Rate Range in One
Standard Deviation 		Number of Properties/
Responses
      lower   upper  
Western States Petroleum Association* 23.90 7.10 16.80 to 31.00 239
Society of Petroleum Evaluation Engineers** 15.40 3.30 12.10 to 18.70 153
Texas Comptroller of Public Accounts-PTD*** 15.47 0.75 14.72 to 16.22 3206
Average 18.26 3.72 14.54 to 21.97  

* Based on combined proved developed producing sales. Annual Study for 2002

** Based on responses for the 21st Annual Survey of Economic Parameters, June 2002

*** Based on the appraisal of 3206 leases in the 2001 Property Value Study less Ad Valorem Tax

The results reported in these studies are used in defining a range of rates suitable for the wide variety of properties in Texas. This year’s range of 17.26 percent to 21.97 percent is defined by the PTD’s base discount rate (see following paragraph) at the low end. The upper end of the range is the average of the “high-end” values shown in the “Range of One Standard Deviation” column of the above table.

Base Discount Rate and Adjustments

PTD added two percentage points to the overall mean WACC of 15.26 percent to establish the current year’s base discount rate of 17.26 percent. The two percentage points, known as the “hurdle rate,” account for a base amount of property-specific risk inherent in all properties.

Adjustments for Property Risk Attributes

Discount rates can be tailored to reflect a wide variety of individual property risk attributes. PTD adjusts the base discount rate upward to account for additional risk associated with individual leases. The base discount rate with adjustments is known as the property specific discount factor. Some common examples of additional risk routinely considered by PTD and their associated adjustments are shown below.

The discussion begins with risks that have specific “number” adjustments built into PTD computer programming and are reviewed for each study-year.

Limited history - Limited production history is frequently cited as the major risk associated with appraising oil and gas properties. Decline curve analysis requires sufficient production history and some knowledge of the reservoir drive mechanism to enhance the confidence level for reserve forecasts.

Type of Risk Added Percentage Point
 
Limited History  
 
less than one year 3
one to two years 2
two to three years 1
more than three years 0
Single Completion Leases - Single completion leases have a greater chance of being abandoned sooner because they do not involve or exhibit the potential for production from additional zones in a single wellbore. Multiple completion wells are not adjusted for risk.
Type of Risk Added Percentage Point
 
Single Completion Lease 1
Offshore Leases - Offshore properties often involve production and economic risks above those associated with onshore properties.
Type of Risk Added Percentage Point
 
Offshore Lease 2
Enhanced Oil Recovery (EOR) Leases - This recovery method, by definition, involves complex production methods and additional economic risks. Early-stage projects have a high uncertainty of success, and pilot projects experience unusual risks associated with expansion throughout the field.
Type of Risk Added Percentage Point
 
EOR Projects Varies from 1 to 3 based on an individual project’s
ranking in the Oil and Gas Journal biennial
EOR Survey
Short Remaining Life - Working interest owners often associate greater insecurity and higher risk with marginal properties approaching their economic limit.
Type of Risk Added Percentage Point
 
Short Remaining Life
(less than 2 years)		 2
Other risk adjustments are not specifically quantified for each study-year and are applied at the appraiser’s discretion to individual properties.

Type of Risk Adjustment Trend
 
High or Increasing Watercut may increase
Erratic Production may increase
Long History-Stable Production may decrease (1 point)
Gas Curtailment may increase (1-2 points)
Environmental Concerns may increase (1-2 points)

Conclusions

A range of discount rates adjusted for individual property risk is well suited to the mass appraisal of a wide variety of petroleum and minerals properties, as found in Texas. Choosing a particular discount rate should be tempered by the appraiser’s perception of risk associated with the property. Based on WACC results, market surveys and sales analyses, PTD concludes that a discount rate range of 17.26 percent to 21.97 percent is appropriate for the mass appraisal of petroleum and hard mineral properties in Texas for the 2002 Property Value Study (PVS).

REFERENCES

  1. Mineral Property Economics, Volume 1: Economics Principles and Strategies, John M. Campbell and Co., Campbell Petroleum Series, Norman, OK (July 1978).
  2. Analysis and Management of Petroleum Investments Risk, Taxes and Time, John M. Campbell & Co., Campbell Petroleum Series, Norman, OK (March 1987).
  3. Standard & Poor’s Bond Guide, Standard & Poor’s Corporation, New York, NY.
  4. S & P Stock Reports, Standard & Poor’s Corporation, 25 Broadway, New York, NY.
  5. Stocks, Bonds, Bills and Inflation, Ibbotson Associates, Chicago, IL (2000 Yearbook).
  6. Fair Market Value Transactions, Cost of Capital, and Risk, January 16, 2002, Richard J. Miller & Associates, Inc., Huntington Beach, CA.
  7. Financial Theory and Corporate Policy, 2nd Ed., Thomas E. Copeland and J. Fred Weston, University of California at Los Angeles, Addison-Wesely Publishing Company, Inc., 1983.
  8. The Twenty-First Annual Survey of Economic Parameters Used in Property Evaluation, June 2002, Society of Petroleum Evaluation Engineers, Houston, TX 77002.
  9. Texas Property Tax Manual for Discounting Oil and Gas Income 1999, Comptroller of Public Accounts, Property Tax Division, Austin, TX, Tax Publication #96-326, August, 1999.
  10. “Which Fair-Market-Value Should You Use?”, Forrest A. Garb, Journal of Petroleum Technology, SPE Paper No. 20276 (January 1990), pp. 8-17.