OT30320 - Capital gains: valuation of oil assets including shares: the discounted cash flow methodology of valuing fields - the process

The Process

The discounted cash flow (DCF) is based on the fundamental theory of value. This states that the value of a financial asset (but not necessarily its open market value) is the sum of the present values of future cash flows stemming from the ownership. It is most commonly used where future income can be estimated with some degree of certainty. As such the LB Oil & Gas accepts it is appropriate for fields and some prospects, but not for exploration acreage.

DCFs are used by people with different interests (e.g. bankers, accountants, oil analysts, economists, petroleum engineers, tax planners) and the terms on which the model is drawn up and the consequential value will reflect their different concerns. As a result, when considering contemporary DCFs any bias present (for example, in the assumptions) will be evaluated. However, even if a DCF has a particular bias it may still yield useful information.

It is common to value a field on a stand-alone basis. To make a company valuation DCFs will have to be consolidated and other factors such as off-setting exploration expenditure or tax overhang will be present, all of which will have a value. It is also necessary to decide whether the resulting figure, the asset value, is the open market value (see OT30320+).

Valuing the asset using a DCF has two stages:

  • a production forecast; and
  • a prediction of the financial performance of the asset, which includes the expected future product prices and expenses.

The production forecast is a prediction of the amounts of the future production of oil and/or other hydrocarbons (production streams) from the asset projected over time - typically 20 to 25 years.

The DCF analysis of those expected production streams determines the present value of the net cash that will be generated in the future from the production and sale of the forecasted amounts of oil less the operating expenses, royalties, and taxes incurred as the production streams are produced. The resulting cash flow stream is discounted to a reference date to arrive at the net present value (NPV).