Best resources for valuing oil & gas assets
"When appraising refineries, look for these primary valuation drivers: plant capacity, utilization (%), gross refining per barrel, operating costs, depreciation and amortization, capital expenditures, and the discount rate," say Siby V. Abraham and Jeffrey W. Kennedy (Deloitte Financial Advisory Services).The two speakers, from Deloitte Financial Advisory Services, were presenters at the first annual Energy Valuation Seminar, hosted last week by the Houston ASA and chapter president Tim Stuhlreyer of Convergent Capital Appraisals.
“There’s a lot of work for all of us in the coming couple of years,” Kennedy added, particularly given industry and economic factors such as consolidation, a shift to independents, regulatory oversight, and liability risks. Further, for valuations within the oilfield services industry (and in light of recent industry events), analysts might consider an upside risk premium adjustment to cover any potential liability risk. But they should also ask themselves: has the market already adjusted for the risk?
For a complete reference library, check out these “best practices” resources for valuing oil and gas reserves, suggested by presenter Allen C. Barron (Ralph E. Davis Associates) and supplemented by our own research:
- “Which Fair-Market-Value Method Should You Use?” by Forrest A. Garb, Journal of Petroleum Technology (Jan. 1990); available for purchase from OnePetro. (But see Discussion of ‘Which Fair Market Value Method Should You Use?’ at RefDoc.fr.)
- Series of Recommended Evaluation Practices by the Society of Petroleum Engineers (SPEE)(2002), featuring Inclusion of Hedging Positions in Reserve Reports, Discounting Cash Flows, Reporting Multiple Rates of Return, and Calculating Internal Rates of Return. See also: “Perspectives on the Fair Market Value of Oil and Gas Interests,” Monograph 2 (2002), and “Guidelines for the Practical Evaluation of Undeveloped Reserves in Resource Plays,” Monograph 3 (2011), both available for purchase at SPEE.
IRS DLOM Job Aid ‘brings nothing new,’ say BV appraisers
As expected, nearly two-thirds (65.1%) of respondents to last week’s online survey say that they have read the IRS DLOM Job Aid, and more than a quarter (27.1%) will in the near future. Only 7% of respondents won’t read the Job Aid or say it’s not relevant to their practice.
What may be more surprising: just over half (53.3%) of respondents who’ve read the Job Aid believe that it adds “nothing new to the discussion” of determining marketability discounts. Of the remaining half, nearly three-quarters (72.7%) believe that the Aid’s most important contribution is its broad overview of DLOM methods, while more than a third (36.4%) focus on its implicit assumption that analysts will have to defend every percentage point of a DLOM above zero.
The Job Aid “shows what [IRS] opinion is and what we have to fight against,” commented one respondent. However, the vast majority (83%) say they don’t expect the Job Aid to impact their current practices other than perhaps changing the emphasis and explanation in reports. Several appraisers are waiting to see how the profession as a whole responds. Other survey insights:
- “It brings nothing new to the table and will change nothing.”
- “It will cause more disputes.”
- “The IRS has not been able to convincingly prove . . . that the restricted stock study method is deficient in any way.”
- “I will only use it when faced with an IRS challenge on discounts, as an insight into their thinking and ‘logic.’ Other than that, I don’t believe much of anything the IRS produces is valuable. Does anybody?”
To find out just how the profession is vetting this document and absorbing it into current tax practices, tune in to BVR’s special 100-minute webinar, FMV Responds to the IRS DLOM Job Aid, featuring Lance Hall (FMV Opinions) on October 12, 2011.
Tax-affecting models: are they relevant
“The liquidity discussion in the BV community is not dissimilar to the one that we have about the effects of taxes on value,” says Nancy Fannon (Fannon Valuation Group), responding to continuing discussions in the BVWire as well as the greater BV professional community.
“Valuation models in place today effectively treat pass-through entity owners as if they were the only investors ‘smart enough’ to benefit from tax savings,” Fannon says. “However, an abundance of academic research (not to mention common sense and the practical advice that CPAs routinely offer their clients) demonstrates that all investors engage in strategies to reduce or avoid taxes. Our current pass-through entity models fail to consider that the benchmark from which analysts adjust value already has a healthy measure of tax-avoidance baked into it,” she says (emphasis added).
Moreover, “investor taxes do not correlate directly with value,” Fannon adds. “Far from it.” As in the case of determining liquidity discounts, “it seems that only the BV community—and those to whom we have perpetuated this view, including the courts and the IRS—ascribes to this notion.” Similar to the liquidity debate, “advances in academic research seem to make little difference to the models that gain favor, persist in our industry, and seem to be perpetuated on every conference agenda,” observes Fannon, who has been speaking and writing on the topic of taxes and value for the past few years. She is currently completing an article with Keith Sellers (Univ. of Denver), with whom she’ll be conducting an AICPA webinar in early 2012; for more information, visit Fannon’s website. For an immediate overview, consider, “Pass-Through Entity Valuation Update: The Significant Impact of Academic Research on the Debate,” a recent BVR webinar featuring Fannon and Sellers (May 2011).
DOL agrees to re-propose its rule on
The U.S. Department of Labor's Employee Benefits Security Administration will re-propose its rule on the definition of a fiduciary, says a new DOL release. “The decision to re-propose is in part a response to requests from the public, including members of Congress, that the agency allow an opportunity for more input on the rule,” says the DOL.
The decision also means that the DOL will receive additional input, review, and consideration from stakeholders such as small business owners and their advisors—including valuation analysts and ESOP appraisers. “Specifically, the agency anticipates revising provisions of the rule including, but not restricted to, clarifying that fiduciary advice is limited to individualized advice directed to specific parties, responding to concerns about the application of the regulation to routine appraisals and clarifying the limits of the rule's application to arm's length commercial transactions, such as swap transactions,” says the DOL. Also anticipated are exemptions related to current fee practices of advisers, such as those that have long permitted brokers to receive commissions in connection with mutual funds, stocks, and insurance products. “The agency will carefully craft new or amended exemptions that can best preserve beneficial fee practices, while at the same time protecting plan participants and individual retirement account owners from abusive practices and conflicted advice.”
BVR exclusive: IRS will present its fractional interest model
Ever since the BVWire reported the IRS’s new model on fractional real property interests (which was a show-stopper at the most recent ASA IRS Symposium in L.A.), analysts have debated and disputed its premise, i.e., that any fractional interest above 30% would be difficult to defend against an implied minority premium. At long last—and in an exclusive presentation—the developer of the IRS model will cap off BVR’s four-part Online Tax Summit:
- Judges Roundtable: View From the Bench, Friday, November 4, featuring Hon. David Laro, Hon. Joseph Robert Goeke, Hon. Julian I. Jacobs, all from the U.S. Tax Court, and moderator Jay Fishman;
Register for all programs in the series (at a discount), or attend each separately.
Non-compete conveys personal goodwill to professional corporation, 9th Circuit confirms
When a dentist incorporated his solo practice back in 1980, he also signed a non-compete, effectively agreeing not to compete against his own corporation (of which he was sole shareholder, officer, and professional employee). More than 30 years later, when he sold the practice to another dentist, he allocated nearly $550,000 of the purchase price to his personal goodwill and then reported the sale on his federal income taxes as long-term capital gain income. After the IRS re-characterized the goodwill as a corporate asset and treated the proceeds as a dividend, the taxpayer sued for a refund in district court, which found for the IRS--and the taxpayer appealed.
Held: the U.S. Court of Appeals for the Ninth Circuit found that under the facts of the case, the dentist effectively transferred his personal goodwill to the corporation through the original non-compete. For federal tax purposes, his professional goodwill became a corporate asset and its sale proceeds constituted a dividend to the taxpayer. Look for the complete digest of Howard v. United States, 2011 WL 3796723 (C.A.9 (Wash.))(Aug. 29, 2011), in a future Business Valuation Update; the 9th Circuit’s opinion will be posted soon at BVLaw, where you can also find the federal district court’s opinion.
For a current, comprehensive guide to valuing dental practices—including sample reports: check out BVR’s Guide to Valuing Dental Practices, edited by Stanley Pollock, who is both a dentist and a business appraiser. The new guide contains two sample appraisals of dental practices and chapters on valuing orthodontic practices as well as professional goodwill.
Values for government contractors still haven’t recovered, says new GT study
Despite the recent rebound in the credit and M&A markets, helped in substantial part by record government spending, “the federal budget deficit is exerting tremendous pressure on government budgets and, hence, government contractors,” says a new Grant Thornton release, The government contractor industry: M&A environment and recent deal trends,” (Sept. 2011):
Over the past 12 months, the government services market has underperformed the broader market. Valuation multiples in the defense and government services market have dropped dramatically since 2005 as defense budgets have flattened out, while the broader markets have actually recovered substantially. The rebound in the public markets has taken place at the same time as budget pressures on government contractors have depressed government contractor valuations.
The new white paper came out of GT’s recent Government Contractors’ Roundtable, which produced several summary reports. Of further interest: look for an analysis of government contractors with a “set aside clarification” by Donald W. Nalley (Beason & Nalley) in the next (November) BVUpdate.
How to avoid the ‘volatility dilemma’ in equity valuations
One victim of the “gut-wrenching” volatility in equity markets has been IPOs, said a recent article in The Wall Street Journal: “With the VIXor ‘fear index,’ hitting extremely high levels of late . . . it is clear investors can’t decide what companies are really worth.”
“So how are poor valuation practitioners supposed to determine the ‘right’ DLOM for a company they are valuing?” asks Ron Seaman (Southland Business Group). “With VIX levels going from the teens to the 40s and back within weeks, what volatility number should they use? Since higher volatility numbers will produce bigger discounts, how can they justify the number? And does the selected number really apply to the subject company or just to the total market?”
One possible solution: Seaman’s study on LEAPS (Long Term Equity Anticipation Securities) avoids the volatility dilemma altogether. “LEAPS put options for the companies (or ETFs) that you choose already contain the market’s volatility estimates for those specific companies, not just for the market as a whole,” Seaman says, who also wrote, “The Effects of Current Economic Troubles on Discounts for Lack of Marketability,” for BVUpdate.
FASB goodwill impairment update may increase cost, complexity for some reporting units
In its just-released Accounting Standards Update No. 2011-08, Intangibles—Goodwill and Other (Topic 350): Testing Goodwill for Impairment, the FASB amends ASC 350 to allow entities to “qualitatively assess whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount,” says the Valuation Research Corporation. If it is “more–likely-than-not” that the fair value of the reporting unit is less than its carrying amount, then the entity would proceed with step one of ASC 350’s two-step goodwill impairment test. However, if a review of qualitative factors indicates that the reporting unit will clear the “more-likely-than-not” hurdle and its fair value exceeds its carrying value, then “no further fair value measurement needs be performed,” say VRC analysts.
“FASB has reduced the complexity of the goodwill impairment testing process with this ruling for certain entities that have reporting units with significant differences between fair value and their carrying amounts,” adds P.J. Patel, VRC senior vice president. “However, it is important to note that for entities that have a significant cushion, the ability to qualitatively assess a reporting unit for goodwill impairment prior to commencing a fair value-based test already existed under ASC 350. The qualitative assessment, together with a more-likely-than-not threshold, should reduce the complexity and cost of goodwill impairment testing for these entities that have a significant cushion. But for those entities with [less] cushion, the new standard can result in the qualitative step providing unclear direction, and perhaps more auditor scrutiny.”
Three attempts to comply with entire market value rule—and Lucent’s expert is all but OUT
Remember when the Federal Circuit reversed a record-setting $358 million award in Lucent v. Gateway, because the plaintiff’s damages expert failed to prove that its patented calendar feature furnished a substantial basis for consumer demand of Outlook? Well, on remand to district court, Microsoft (Gateways’ successor) immediately challenged the plaintiff’s new damages expert under Daubert. On the day of the hearing, however, the Federal Circuit issued Uniloc v. Microsoft, which abolished the 25% “rule of thumb” and required plaintiffs “in every case” to apportion damages between the patented/unpatented features of the accused product, and the Lucent court postponed the hearing to permit both sides to re-brief the issue.
When the hearing resumed, Lucent’s expert submitted an “apportionment analysis” that discounted Outlook’s base revenue by the percentage of consumers who used the patented feature, resulting in $73.8 million in damages. This still used the entire market value of Outlook, the court held, and sent the parties back for a third try. This time, Lucent’s expert submitted three different approaches—but the court disallowed all but one, a Georgia-Pacific analysis, which would still be subject to continuing objections under the entire market value rule. Read the complete digest of Lucent Technologies, Inc. v. Microsoft Corp., 2011 WL 2728317 (S.D. Calif.)(July 13, 2011) in the current BVUpdate; the court’s opinion is already posted at BVLaw,
Keep current on the rule. Since Uniloc, we’ve covered nearly half a dozen new cases that interpret expert damages evidence under the courts’ more stringent application of the entire market value rule. This Thursday, October 6, don’t miss Craig Jacobson (Citrin Cooperman) and Stephen Lieb (Frommer Lawrence & Haug) in “Patent Damages: The Entire Market Value Rule.” This installment of BVR’s Online Symposium on Litigation & Economic Damages will discuss how the increasing dominance of intellectual property as a value-driver has placed a new burden on patent damages in general and entire market value analysis in particular.
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