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The concept of a market value applies most readily to identical commodities in which it is possible to record a sufficient number of transactions between willing buyers and sellers in order to establish the "market". This would apply to such diverse items as shares of American Telephone and Telegraph traded on the New York Stock Exchange or as wheat futures traded on a commodity exchange. Each represents a large number of transactions in identical items and a means is provided for recording each transaction. Establishment of market value--even though it may fluctuate from day to day--is comparatively simple. In the case of a mineral lease, however, these two criteria of effective markets are violated on both counts. Leases are not commodities. Two blocks of acreage adjoining one another may be valued totally differently by knowledgeable observers trying to value them. Since the blocks themselves literally are not the same, it is hard to establish a measure by which a large number of transactions between willing buyer and seller can establish the "market".

The nearest it appears to be possible to come to "market valuatinn" for mineral leases occurs in the buying and selling of proved mineral properties--particularly oil and gas properties--where it is possible to obtain an independent engineer's valuation of the lease. If the information is available publicly (rather than just held confidentially between the buyer and seller), the "market" value of properties can be stated as the trend or current pattern of percentage of the engineer's valuation actually reached in a group of transactions. However, even here there are problems as different engineers' valuations of the same properties may differ, and rarely is enough public data about transaction values, relative to the valuations, available to provide realistic "market" information. There may be rules of thumb occasionally referred to in industry papers, but no real marketplace data exists.

The reservoir engineer's evaluation is done by estimating the reserves underlying the acreage--determining the physical factors that will establish the rate of production of those reserves in each future year to economic exhaustion. Then by estimating operating costs, and revenues from the future mineral production, it is possible to develop a cash flow profile year by year into the future until reservoir exhaustion.

Arthur D Little Inc The cash flow profile can be discounted at current interest rates to calculate the discounted present value of the future cash flows from the property. Since companies are generally unwilling to put their money in oil properties to yield a return equivalent to current interest rates (preferring to invest them in a bank directly instead) the property trading values are usually reduced from the engineer's figure.

Conceptually, at least, the process of valuing a discovered, but undeveloped lease (such as an offset block in a drainage sale, for example) or a rank wildcat exploratory lease is much the same. In the first case, the proved valuation must be adjusted for the cash outflows for drilling and development. Since the lease has not been fully developed, the estimates of underlying reserves are less certain and it should be further discounted for the resulting risk. In the case of the wildcat block, probabilistic estimates of the chance of a discovery will sharply reduce the prospective value (calculated on a discovered basis). This is particularly true in new areas where little information may be available to estimate the nature of a successful discovery. In practice companies often approach the estimating of wildcat block values in quite different ways, reflecting their substantial uncertainty. A further complication in a sealed bid lease sale, such as those held in the ocs, is that companies may further superimpose a bidding strategy on their own valuation so that they can expect to win some fraction of the leases they actually bid for in competition with other companies having basically the same fundamental information.

What does all of this mean to the administration of a leasing program?

Since the leases offered are either development or exploratory the lease administering agency is usually faced with determining "fair market value" in the latter two more difficult cases. The Bureau of Land Management, for example, is often faced with determining whether the fair market value test has been met in an ocs lease sale where unproved acreage is up for bid. There is only one "seller" but several "buyers" to determine the market for a given block. BLM, therefore, has two options:

1. It can assume that the highest bidder has set the fair

market value and accept it; or

Arthur D Little Inc 2. It can develop its own independent judgment of what

it thinks is fair market value, and accept or reject
the high bid depending upon its view of whether the bid

has or has not met that test. The Department of the Interior seems to be moving in the latter direction by developing its own judgment of the mineral value of each lease utilizing not only data which is supplied by other leaseholders but also participating in offshore seismic programs in order to get advanced geophysical data of the type which the bidders use in order to determine their own bid values

on leases.

Since individual reservoir engineers can disagree on the underlying data which are used to calculate the present value of proved properties and therefore get differing estimates, of even fairly risk-free properties, the more the input information is of an exploratory or speculative nature (as would be the case of exploratory acreage) the more room there is for disagreement on the basic assumptions and therefore the estimate of different values as between companies. This is evident in the bidding data from sealed bids that have been conducted publicly to date. Often companies will disagree significantly and there will be a substantial spread in value of bid between different companies at a given sale.

Sometimes companies' bids can be fairly close together as was the case in the September 1969 Alaskan lease sale where two companies bid within $200,000 of one another on a $72 million bid for Block No. 57. In contrast in the same sale, one group with adjoining acreage one side of Block No. 37 bid $42 million, where a competitive group having a lease also adjoining, placed the second highest bid of $2 million for the same Block No. 37--a difference of $40 million. Obviously, where the two companies so significantly disagreed on their bid values, how could any leasing agency feel very confident with the "fair market value" test? Similarly, in the offshore Texas sale of May 1968. one company bid $44 million for Brazos Block 506 and the second highest bidder came in at $16 million based on a quite different judgement of the geological prospects from this

wildcat acreage. Clearly to the extent that the Department of the Interior must estimate "fair value" based on its own assessment of the geological prospects on a given block, it would be subject to the same broad uncer

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tainties in highly risky acreage that individual company bidders are.
Thus the dilemma is that the concept of fair value is probably fairly
workable in situations that are certain--such as drainage sales. But in
the areas we really need to promote--where real exploration at high risk
is required--it fails to be significantly useful. This same situation,
of course, especially plagues leases of technological risk--such as shale
or coal for synfuels. Here it is even less likely that there is one
right "fair market value" answer. The real national problem with the
approach is thus that it will be applied in the wrong way and inhibit an
orderly and even flow of leases for exploration, research, and development.

This will especially be true if it is applied retrospectively as a test of whether the administration of the leasing program has been in the public interest. If bidders are valuing exploratory leases in an area where the expected success ratio is no better than one in five, they would be foolhardy indeed to bid prospectively in a wildcat sale more than one fifth the value of a successful lease on any one. If the lease administration is later judged retrospectively as having conducted a giveaway of public resources of accepting only one-fifth the retrospective value of the successful lease, while no one worries about the four retrospectively worthless leases which were also leased for one-fifth the value of a success, the system introduces a "heads-I-win; tails-youlose" judgment of the process which makes it administratively unworkable.

Relative Merits of Alternatives to the Cash Bonus Fixed Royalty Bidding System

The typical method of Federal sealed bid leasing such as for the outer continental shelf has been by fixed royalty percentage and a variable cash bonus bid. This practice has been criticized on two grounds. One of these is that the very high cash bonuses, particularly for attractive acreage, are often beyond the reach of any but the largest cor orations and therefore have the effect of reducing competition for acreage by independents. The second criticism is that the large magnitude of the cash bonuses in recent years has been significant compared to the capital expenditure budgets of the petroleum industry. Those who see an industry cash flow shortage believe that cash bonus bidding reduces the availability of badlyneeded funds for exploration itself. The most common variant suggested,

Arthur D Little Inc and one which is included in the outline, is that of a variable royalty against a fixed cash bonus. An intermediate approach would be a delayed cash bonus together with the fixed royalty percentage now in use.

In addition to the effects of permitting more independent competition for high bid blocks, and of reducing the diversion of current industry cash flow into bonuses and away from exploration, the variable bonus system has the effect of shifting the balance of exploratory risk and rewards between the operator and the Federal government. In any bid the amount of the cash bonus is independent of whether or not there is a subsequent discovery, and of the magnitude of the discovery. The absolute amount of royalty paid is a function of the subsequent production level and therefore is directly related to the magnitude of a discovery. Thus the government has more to lose in a dry hole and more to gain from a sizable discovery under a variable royalty system than would be the case under a variable bonus system. This is the same as saying that the government takes a higher risk position (and receives a higher proportion of the revenues which successful risk taking implies) where exploratory bidding is done by the variable royalty system. The delayed cash bonus does not, of course, have this effect. Such a variable royalty bidding system should make it easier to get competition for exploration on high risk exploratory blocks, although to the extent that there is no work commitment it makes it easier for the leaseholder to sit on a lease since he has less sunk cost in the lease bonus. The net effect, however, would appear to be to stimulate risky exploration.

This does not apply equally to those situations such as shale and synfuels from coal where the risks are more of a technological and market nature than they are of dry hole and discovery size. If a shale oil or coal process fails to work as anticipated or costs are out of line, the value of the mineral lease may be zero or negativ from a retrospective point of view. Here government can not sigcificantly alter its risk position relative to industry if it desires to do so unless it does get involved in the risk-reward cycle either indirectly through tax incentives and public research funding or directly through some form of share-of-theprofits bidding, such as is increasingly being practiced in disguised form by foreign producing governments.

Should the Federal Government move increasingly into more complex leasing formulas, it will of necessit have to

e emphasize the comf ng

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