Discount Rate Range for Oil and Gas Properties
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Discount Rate Range for Oil and Gas Properties

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

As part of the annual PVS, the Texas Comptroller’s Property Tax Division (PTD) calculates a range of discount rates used to discount the future income of oil and gas produced from petroleum properties. For the 2004 PVS, the PTD will use a range of 16.97 percent to 22.55 percent unless property-specific attributes require utilization of a discount rate outside this range.

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

Petroleum Appraisal

A primary economic parameter in petroleum property appraisals is the discount rate that is used to convert the future value of an income stream to a present day value. Each year the PTD calculates a discount rate based upon the overall mean weighted average cost of capital (WACC) of several petroleum companies. The PTD adds two percentage points to the overall mean WACC to establish the base discount rate for all properties included in the annual PVS. The two percentage points, known as the hurdle rate, account for a base amount of risk inherent in all petroleum properties. The PTD adds property-specific risk to the base discount rate to calculate an adjusted discount rate for individual properties. The adjusted discount rate should generally fall within the discount rate range that is determined each year. Additionally, the PTD adds the appropriate ad valorem tax rate to the adjusted discount rate to determine the property-specific discount factor that is applied in the PTD’s appraisals to discount the future income of oil and gas produced from individual petroleum properties.

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 petroleum properties in Texas.

The PTD, like a typical investor, will account for expected increases or decreases in product prices when appraising petroleum property. The Texas Comptroller’s Revenue Estimating Division prepares an annual oil and gas price escalation forecast pursuant to Texas House Bill 925, 73rd Legislature (codified as Section 23.175, Property Tax Code).

The PTD typically uses the percent of change forecasted for commodity prices in their appraisals. Appraisal districts may not exceed the forecast in valuing petroleum properties for ad valorem tax purposes.

Discount Rate

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 Oil and Gas Lease Sales Study and Market Survey Methods

The Western States Petroleum Association commissions an annual study of 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-Third Annual Survey of Economic Parameters Used in Property Evaluation, June 2004 is an annual opinion poll survey. Responses from petroleum company executives, industry consultants and energy banks concerning property acquisitions and divestitures offer insight into the discount rates used to analyze properties in the market.

The Weighted Average Cost of Capital (WACC) Method

Each year the PTD conducts a discount rate study to calculate the WACC for several petroleum companies that have operations in Texas. The companies are listed on the New York Stock Exchange (NYSE) or the Over The Counter (OTC) market. The PTD groups these companies as integrated or non-integrated petroleum companies. The integrated companies conduct operations from the reservoir to the gasoline pump, while the non-integrated companies conduct operations from the reservoir to the pipeline. The PTD calculates a discount rate based upon the average of the companies’ weighted average cost of capital (WACC).

For the 2004 PVS, the PTD compiled year-end 2003 financial data for 21 integrated and non-integrated petroleum companies to calculate the WACC for each company. Results of the WACC calculations are presented in Table 1 and Table 2. Considering the combined results of both groups, the overall mean WACC for the 21 companies is 14.97 percent with a standard deviation of 1.29 percent.


Table 1: Integrated Petroleum Companies’ Financial Information Used for WACC Method
(The mean WACC is 14.98 percent with a standard deviation of 1.31 percent for 12 integrated companies.)

Integrated Petroleum Companies
Company Name Total
Capital 		Total
Equity 		Total
Convertible
Preferred
Stock 		Total
Debt 		Equity
% of
Capital 		Convertible
Preferred
Stock
% of
Capital 		Debt
% of
Capital 		Beta
Factor 		After
Income
Tax
Cost of
Equity, % 		Before
Income
Tax
Cost of
Equity, % 		Cost of
Convertible
Preferred
Stock
% 		Cost of
Debt
% 		Before
Income
Tax
WACC
%
Amerada Hess $8,756,531,560 $4,778,281,560 $47,250,000 $3,931,000,000 54.57 0.01 44.89 0.90 12.14 18.68 0.07 5.61 12.75
Anadarko $18,066,550,000 $13,007,550,000 $0 $5,059,000,000 72.00 0.00 28.00 0.85 11.81 18.17 0.00 4.66 14.39
Apache $15,160,427,641 $12,833,461,641 $0 $2,326,966,000 84.65 0.00 15.35 0.80 11.48 17.66 0.00 5.07 15.73
Burlington Resources $14,818,790,710 $10,945,790,710 $0 $3,873,000,000 73.86 0.00 26.14 0.75 11.15 17.15 0.00 5.24 14.04
Chevron Texaco $103,257,671,531 $92,363,671,531 $0 $10,894,000,000 89.45 0.00 10.55 0.80 11.48 17.66 0.00 3.62 16.18
Conoco Phillips $62,769,139,810 $46,429,139,810 $0 $16,340,000,000 73.97 0.00 26.03 0.85 11.81 18.17 0.00 4.47 14.60
Exxon Mobil $274,044,000,000 $269,288,000,000 $0 $4,756,000,000 98.26 0.00 1.74 0.80 11.48 17.66 0.00 4.43 17.43
Kerr-McGee $7,770,001,391 $4,689,001,391 $0 $3,081,000,000 60.35 0.00 39.65 0.95 12.47 19.18 0.00 4.79 13.48
Marathon $14,356,851,009 $10,271,851,009 $0 $4,085,000,000 71.55 0.00 28.45 0.85 11.81 18.17 0.00 4.88 14.39
Murphy $7,090,375,755 $6,000,068,755 $0 $1,090,307,000 84.62 0.00 15.38 0.85 11.81 18.17 0.00 5.44 16.21
Occidental $20,367,905,324 $16,348,905,324 $0 $4,019,000,000 80.27 0.00 19.73 0.85 6.20 18.17 0.00 4.27 15.43
Unocal $12,232,677,020 $9,597,677,020 $0 $2,635,000,000 78.46 0.00 21.54 0.85 11.81 18.17 0.00 4.38 15.20
TOTAL $558,690,921,750 $496,553,398,750 $47,250,000 $62,090,273,000 922.01 0.01 277.45 10.10 135.45 217.02 0.07 56.85 179.82
ENTRIES         12 1 12 12 12 12 1 12 12
AVERAGE         76.83 0.005 23.12 0.84 11.29 18.08 0.07 4.74 14.98
STANDARD DEVIATION         12.02 0.002 11.93 0.05 1.64 0.52 0.02 0.56 1.31


Table 2: Non-Integrated Petroleum Companies’ Financial Information Used for WACC Method
(The mean WACC is 14.95 percent with a standard deviation of 1.34 percent for 9 non-integrated companies.)

Integrated Petroleum Companies
Company Name Total
Capital 		Total
Equity 		Total
Convertible
Preferred
Stock 		Total
Debt 		Equity
% of
Capital 		Convertible
Preferred
Stock
% of
Capital 		Debt
% of
Capital 		Beta
Factor 		After
Income
Tax
Cost of
Equity, % 		Before
Income
Tax
Cost of
Equity, % 		Cost of
Convertible
Preferred
Stock
% 		Cost of
Debt
% 		Before
Income
Tax
WACC
%
Cabot Oil & Gas $1,216,116,474 $946,116,474 $0 $270,000,000 77.80 0.00 22.20 0.95 12.47 19.18 0.00 6.03 16.27
Devon Energy $22,099,086,000 $13,519,086,000 $0 $8,580,000,000 61.17 0.00 38.83 0.80 11.48 17.66 0.00 4.65 12.61
EOG Resources $6,460,455,168 $5,351,583,168 $0 $1,108,872,000 82.84 0.00 17.16 0.85 11.81 18.17 0.00 4.09 15.75
Forest $2,460,042,864 $1,530,071,864 $0 $929,971,000 62.20 0.00 37.80 0.90 12.14 18.68 0.00 6.24 13.98
Newfield Exploration $3,149,081,642 $2,505,622,642 $0 $643,459,000 79.57 0.00 20.43 0.85 11.81 18.17 0.00 5.82 15.65
Noble Energy $3,317,177,389 $2,541,156,389 $0 $776,021,000 76.61 0.00 23.39 0.80 11.48 17.66 0.00 6.82 15.13
Pioneer Natural Resources $5,364,319,560 $3,808,858,560 $0 $1,555,461,000 71.00 0.00 29.00 0.95 12.47 19.18 0.00 4.73 14.99
Pogo Producing $3,566,768,729 $3,079,507,729 $0 $487,261,000 86.34 0.00 0.14 0.85 11.81 18.17 0.00 7.39 16.70
Vintage Petroleum $1,473,245,824 $773,302,824 $0 $699,943,000 52.49 0.00 47.51 0.95 12.47 19.18 0.00 7.23 13.50
TOTAL $49,106,293,651 $34,055,305,651 $0 $15,050,988,000 650.01 0.00 236.46 7.90 107.94 166.06 0.00 53.00 134.57
ENTRIES         9 0 9 9 9 9 0 9 9
AVERAGE         72.22 0.00 26.27 0.88 11.99 18.45 0.00 5.89 14.95
STANDARD DEVIATION         11.34 0.00 14.03 0.06 0.41 0.63 0.00 1.18 1.34


Base Discount Rate for all Oil and Gas Properties in the Property Value Study

The PTD adds two percentage points to the overall mean WACC of 14.97 percent to establish the base discount rate of 16.97 percent for the 2004 PVS. The two percentage points, known as the hurdle rate, account for a base amount of risk inherent in all petroleum properties.

Adjusted Discount Rate

The base discount rate may be tailored to reflect a wide variety of individual property specific risk attributes. The PTD adjusts the base discount rate to account for specific risk associated with individual properties or leases. This is known as the adjusted discount rate. Some common examples of risk routinely considered by the PTD and the associated adjustments are shown below. The examples begin with risk adjustments built into the PTD’s computer programming that are automatically included in the adjusted discount rate on a property-specific basis.

Limited History - Limited production history is frequently cited as the major risk associated with appraising petroleum 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 early abandonment because they do not involve or exhibit the potential for production from additional zones in a single well bore. Multiple completion wells are not adjusted for this risk.

Type of Risk Added Percentage Points
Single Completion Lease 1

Offshore Leases - Offshore properties often involve production and economic risks greater than those associated with onshore properties.

Type of Risk Added Percentage Points
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 Points
EOR Projects Varies from 1 to 3 based on an individual project's ranking in the Oil and Gas Journal biennial EOR Survey

Other Adjustments - Risk adjustments not specifically quantified in the PTD’s computer programming may be applied to individual properties or leases at the appraiser’s discretion.

Type of Risk Adjustment Trend
Short Remaining Life (< 2 years) may increase (1 or 2 points)
High or Increasing Water Cut may increase
Erratic Production may increase
Long History-Stable Production may decrease (1 point)
Gas Curtailment may increase (1 or 2 points)
Environmental Concerns may increase (1 or 2 points)

Reconciling Results into the Discount Rate Range

The PTD establishes the upper end of the discount rate range by reconciling study and survey data compiled by the Western States Petroleum Association, the Society of Petroleum Evaluation Engineers and the Comptroller’s Property Value Study. Similarities are evident in comparing the statistical results of the data; however, the differences also highlight contrasting views in the market. Table 3 summarizes the results.

Table 3: Summary of Findings for Annual Sales Study, Industry Survey, and 2003 Property Value Study

   Discount Rate Range 
Study Author Discount Rate Standard Deviation Lower   Upper Data Points
Western States Petroleum Association * 23.20 6.30 16.90 to 29.50 160
Society of Petroleum Evaluation Engineers ** 15.70 3.79 11.91 to 19.49 154
Texas Comptroller of Public Accounts - PTD *** 17.52 1.15 16.37 to 18.67 7928
Average 18.81 3.75 15.06   22.55  
     * Discount Rate based on 160 PDP property transactions: "Fair Market Value Transactions, Cost of Capital, and Risk," January 29, 2004
   ** Discount Rate based on 154 survey responses: "Survey of Economic Parameters Used in Property Evaluation," June 2004
*** Discount Rate based on the appraisal of 7,928 leases (less ad valorem taxes): "2003 Property Value Study"

The results in Table 3 are used to quantify the range of discount rates suitable for appraising the wide variety of petroleum properties in Texas. This year’s discount rate range of 16.97 percent to 22.55 percent is defined at the low end by the PTD’s base discount rate. The upper end of the discount rate range is the average of the “high-end” values shown in the Upper Discount Rate Range column of Table 3.

Conclusions

A range of discount rates adjusted for individual property risk is appropriate to the mass appraisal of a wide variety of petroleum properties found in Texas. Utilization of a particular adjusted discount rate should be tempered by the appraiser’s perception of risk associated with the property. Based on the WACC results, market survey, sales analyses and studies, the PTD concludes that a discount rate range of 16.97 percent to 22.55 percent is generally suitable for the mass appraisal of petroleum properties for the 2004 Property Value Study. The PTD adds the appropriate ad valorem tax rate to the property-specific adjusted discount rate to determine the discount factor that is applied in the PTD’s appraisals to discount the future income of oil and gas produced from individual petroleum properties.

References

  1. Analysis and Management of Petroleum Investments Risk, Taxes and Time. John M. Campbell & Co., Campbell Petroleum Series, Norman, Oklahoma, March 1987.
  2. Fair Market Value Transactions, Cost of Capital and Risk. Richard J. Miller & Associates, Inc., January 29, 2004.
  3. 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.
  4. Mineral Property Economics, Volume 1: Economics Principles and Strategies. John M. Campbell and Co., Campbell Petroleum Series, Norman, Oklahoma, July 1978.
  5. Society of Petroleum Evaluation Engineers. The Twenty-Third Annual Survey of Economic Parameters Used in Property Evaluation. Houston, Texas, June 2004.
  6. Standard & Poor’s Bond Guide, 2003 Year-End Prices. Standard & Poor’s Publishing, January 2004.
  7. Stocks, Bonds, Bills and Inflation, 2004 Valuation Edition Yearbook. Ibbotson Associates, Chicago, Illinois.
  8. Texas Comptroller of Public Accounts, Property Tax Division. Texas Property Tax Manual for Discounting Oil and Gas Income 1999. Tax Publication #96-326. Austin, Texas, August 1999.
  9. The Wall Street Journal. The Dow Jones & Company, January 2, 2004.
  10. U.S. Securities and Exchange Commission. Form 10-K Annual Reports, Year-End December 31, 2003, Washington, D.C.
  11. Value Line Investment Survey, 2003 Ratings and Reports. Value Line Publishing Company, New York, New York.
  12. Which Fair-Market-Value Should You Use? Forrest A. Garb, Journal of Petroleum Technology, SPE Paper No. 20276, January 1990.