Beneath the Surface: Valuing
Oil and Gas Assets in Litigation
By Cagatay Koc, Tom Ross, and John Szczepanski
R
ecent technological developments in the oil and gas
industry have provided access to vast new reserves
throughout the world and led to significant growth in
oil and gas production. The recent expansion in drilling and
producing operations has also coincided with an increase in
litigation and international arbitration related to oil and gas
assets. This is largely because of the capital-intensive, long-
term, and multiparty nature of oil and gas development.
Central to much of this litigation are issues affecting these
assets fair market value. Although the valuation methods for
other assets are similar, the characteristics of this industry
deserve special consideration in a litigation context. This
article considers four of these characteristics:
Estimation of cash flows in discounted cash flow
(DCF) valuation of oil and gas assets through the
use of decline curves;
Use of discount rates to address the varying degrees
of market risk underlying the types of reserves being
valued;
Comparables valuation metrics commonly used in oil
and gas assets valuation; and
The acreage pricing method for valuing assets with
undeveloped reserves.
Oil and Gas Litigation Will Likely Increase
Litigation involving oil and gas assets will likely increase
for two primary reasons. First, recent technological devel-
opments, such as hydraulic fracturing (fracking) and
horizontal drilling, have greatly increased the amount of
recoverable reserves from known reservoirs. In addition,
Cagatay Koc (ckoc@cornerstone.com), PhD, is a principal,
and Tom Ross (tross@cornerstone.com), MBA, CFA, and
John Szczepanski (jszczepanski@cornerstone.com), MBA,
are associates in the Washington, D.C., office of Cornerstone
Research. The views expressed in this article are solely those
of the authors, who are responsible for the content, and do
not necessarily reflect the views of Cornerstone Research.
Published in International Law News, Volume 44, Number 3, 2015. 2015 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion
24 thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
fracking and horizontal drilling have also spurred the devel-
opment of lower-cost and more readily available fuel sources,
such as shale gas and oil. This has effectively expanded the
worlds supply of oil and gas and sparked a rapid increase in
shale development. This rise in development, combined with
the complexity of oil and gas operations, will likely cause a
variety of disputes that may lead to more litigation.
Second, the current decline in oil prices is likely to increase
the number of transactions, and consequently, cause more
potential contract and royalty disputes. For example, a recent
three-part article in Law360 noted that the decline in oil prices
has producers in Eagle Ford and other large plays (groupings
of oil or gas fields with similar characteristics) attempting
to cut costs and scale back operations. Jess Davis, Sinking
Oil Prices Drive Fresh Legal Work in Eagle Ford, Law360 (Feb.
10, 2015). While operators struggle and reduce operations,
production declines will cause a decrease in royalties paid
to landowners, which may lead to an additional wave of
lawsuits. The decline in cash flows may also lead to more
transactions as operators consider buying assets at discounted
values.
Oil and gas development issues have also been a growing
cause of international arbitration. In its 2014 Annual Report,
the International Centre for Settlement of Investment Disputes
(ICSID) noted that it administered a record 209 cases in 2014,
including 40 new ICSID-registered cases and eight new cases
under United Nations Commission on International Trade
Law (UNCITRAL) Arbitration Rules. The report notes that
10 of the new cases were brought on the basis of the Energy
Charter Treaty (ECT), compared with just one case brought
under the ECT in 2013. Importantly, 35 percent of the new
cases under ICSID involved oil, gas, and mining issues, mak-
ing that segment the most commonly arbitrated by the ICSID.
Valuing Oil and Gas Assets
Valuation issues are central to many types of litigation relat-
ing to the oil and gas industry. Since oil and gas assets
represent the majority of a developers value, the method
by which reserves are valued plays a significant role in any
 transaction. Contract and royalty disputes among stakehold-
ers in a reservoir are also sensitive to valuation issues that
determine the economic relationships among the parties.
With the growing importance of oil and gas assets in
litigation and international arbitration, it is crucial to under-
stand some of the common methods of determining their
value. An initial consideration is the appropriate standard of
value. Fair market value is the most widely accepted stan-
dard in oil and gas valuation. As defined in the Litigation
Services Handbook, fair market value is
[t]he price, expressed in terms of cash equivalents,
at which property would change hands between a
hypothetical willing and able buyer and a hypotheti-
cal willing and able seller, acting at arms length in an
open and unrestricted market, when neither is under
compulsion to buy or sell and when both have rea-
sonable knowledge of the relevant facts.
Litigation Services Handbook: The Role of the Financial Expert
10-27 to -28 (Roman L. Weil et al. eds., 5th ed. 2012).
As with most other assets, there are multiple ways to value
oil and gas reserves. Two of the most common methods are
the income approach and the market approach. The income
approach, commonly implemented through a DCF analysis,
relies on the basic financial premise that the value of an asset
is derived from the cash flows that the asset is expected to
generate in the future. To value an oil and gas asset, a pro-
jected stream of future cash flows is first developed based on
production expectations for the reservoir at issue.
The market approach, or market comparables method,
is based on the fundamental assumption that similar assets
should have similar values. This valuation method can pro-
vide a check on the reasonableness of a DCF valuation.
The analyst first identifies transactions that are comparable
to the property being valued. A valuation metric is then cal-
culated for each transaction as the ratio of the transaction
value to a given performance measure (e.g., proved reserves,
daily production). Finally, the value of the oil or gas prop-
erty is estimated by multiplying the selected valuation metric
from the comparable transactions to the corresponding mea-
sure for the property being valued. Although these methods
are generally straightforward, their use in the context of oil
and gas valuation deserves closer consideration.
Estimating Production from Reserves
Using Decline Curves
Anticipated future production from a reservoir, perhaps the
Published in International Law News, Volume 44, Number 3, 2015. 2015 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion
thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
most important factor in an oil and gas DCF valuation, is
derived from a detailed statistical and engineering analysis
of the reserves in question. As a well produces oil and/or
gas, economically recoverable reserves are depleted, and
will ultimately decline to zero. A decline curve estimates
the rate at which the production from an oil or gas well will
decline on the basis of two variables: (1) the wells initial
production rate at the time of the estimate, and (2) a math-
ematical formula that relates the initial production to the
wells production in the future.
The parameters of the mathematical formula for proved
reserves are typically estimated utilizing the known produc-
tion data on the well in question and/or similar wells in the
same area. Past production trends are extended to the point
where production from the well no longer justifies the costs
of operation. The rate at which a wells production declines
depends on where it is in its lifecycle. Oil and gas wells typi-
cally reach their highest daily production rate shortly after
they are drilled and completed. Once production begins to
decline, the rate of decline can change over the life of the well.
The different decline rates are factored into the analy-
sis through the use of different functions to build the trend
lines. For example, a hyperbolic function, as demonstrated
in the early part of the decline curve above, often applies
to the early years of a shale wells life. Use of a hyperbolic
function in a decline-trend analysis results in a steep decline
in the wells forecasted production level. Following a wells
early years, the decline typically levels off, resulting in a
shallower decline curve over the remainder of the wells
useful life. This type of decline curve is calculated through
an exponential decline function. The specific models used
in determining the appropriate decline curve will depend
25
 on the wells characteristics. For example, horizontal wells
drilled in the Niobrara formation of the Denver-Julesburg
basin in Colorado typically follow a hyperbolic decline curve
in their first eight to 10 years, followed by an exponential
curve for the remainder of their useful life.
Estimating Production from Reserves Using Type Curves
Since undeveloped wells have no past production data,
their future production is estimated through the use of type
curves. Type curves are very similar to decline curves except
that the entire curve is based on assumptions derived from
While benchmark
discount rates exist
within the industry,
they are only a starting
point for determining
the discount rate.
comparable wells in the area or play. These inferences are
established through a process known as de-risking, in which
a developer will strategically develop wells in a given area to
gain a better understanding of the characteristics of the res-
ervoir. As more wells are drilled, more information becomes
known about the production potential of future wells. Type
curves use averages of historical data for these initial wells
to predict the two parameters needed to produce the curve.
Since they are based on historical information, type curves are
commonly updated as more information becomes available.
How Discount Rates Capture the Varying Degrees of
Market Risk Underlying the Types of Reserves
Once a reasonable cash flow estimate has been developed,
the cash flows are discounted to obtain a present value. The
discount rate for a given asset will depend on the time value
of money and the risks associated with the asset. In general,
risks can be categorized into project-specific (diversifiable)
and market (non-diversifiable) risks. Project-specific risks are
unique to a particular project (e.g., the risk of a well having
lower-than-expected reserves). Because project-specific risks
can be eliminated by holding a diversified portfolio of invest-
ments, these risks are not reflected in the discount rate. Market
Published in International Law News, Volume 44, Number 3, 2015. 2015 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion
26 thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
risk is the risk that an assets value will change in response to
changes in the overall market (e.g., a decrease in oil prices).
Unlike project-specific risks, market risks cannot be eliminated
through diversification and are reflected in the discount rate.
While benchmark discount rates exist within the industry,
benchmarks should be used only as a starting point for deter-
mining the applicable discount rate. One benchmark discount
rate that is commonly used in reserve reporting is the 10 per-
cent rate prescribed in the financial reporting guidelines of
the Securities and Exchange Commission (SEC), commonly
called PV10. PV10 was developed in the late 1970s by the
Financial Accounting Standards Board (FASB) and the SEC to
address the issue of inconsistent reserve reporting by indus-
try participants. The guidelines issued by the SEC and FASB,
specifically FAS No. 69, established the standardized measure
of oil and gas, which requires that all companies report the
value of future reserves on a standard PV10 basis. However,
the guidelines clearly state that the PV10 value of reserves
should not necessarily be considered a measure of fair market
value. As a result, although PV10 provides a convenient basis
for comparing reserves across different companies, specific
risk factors must be considered when developing a discount
rate for oil and gas assets.
One of the most important factors is the type of reserves
being valued. Oil and gas reserves are generally categorized
as either proved or unproved. Proved reserves are quan-
tities of petroleum that can be estimated with reasonable
certainty to be commercially recoverable from a known
reservoir under current economic conditions, operating
methods, and government regulations. Proved reserves are
in turn categorized according to their production and devel-
opment status, ordered by increasing level of market risks
such as commodity price risk, increases in government reg-
ulation, and industry-wide cost inflation:
Proved developed producing (PDP) reserves are expected
to be recovered from a well currently producing.
Proved developed non-producing (PDNP) reserves are
expected to be recovered from existing wells that are not
currently producing or that require additional completion.
Proved undeveloped (PUD) reserves are expected to
be recovered from new wells on undrilled acreage
or require a relatively large expenditure in order to
recomplete an existing well.
These varying degrees of market risks for different reserve
types should be captured in the discount rate used to value
the reserves. Under the SECs PV10, for example, it would be
 inappropriate to value both PDP and PUD reserves. To illustrate
this point, consider the difference in commodity price risk, a
type of market risk, between PDP and PUD reserves. While
PDP reserves are expected to be recovered from an already pro-
ducing well, PUD reserves may not be developed for several
years. PDP reserves are expected to be produced before PUD
reserves and are therefore less exposed to changes in commod-
ity prices. Economists typically apply higher discount rates
(than PV10) for reserves that are less likely to be recovered in
order to account for the relatively higher market risk.
Comparable Transaction Metrics Commonly Used in Oil
and Gas Assets Valuation
When analyzing oil and gas transactions, valuation metrics
for the market comparables method are frequently calculated
on the basis of current production or proved reserves. One
of the most common valuation metrics measures the dollars
paid per barrel of oil equivalent (BOE) acquired (typically,
in terms of proved reserves). For example, suppose that a
comparable property to the one being valued has two mil-
lion BOE of proved reserves and was recently acquired for
$20 million. The valuation metric for this transaction can
be calculated as the $20 million purchase price divided by
proved reserves of two million BOE, or $10/BOE. The sub-
ject property may then be valued by multiplying $10/BOE by
the proved reserves for the subject property. For developed
properties with significant current production, $/daily BOE
is an additional commonly used metric, which measures the
dollars paid per BOE of daily production.
As an important caveat, oil and gas transactions often
include other assets besides proved reserves, and it may be
inappropriate to ascribe the full transaction value to proved
reserves. For example, in addition to proved reserves, a given
transaction may also include significant undeveloped acre-
age. Therefore, before calculating a metric such as $/BOE, it
may be necessary to adjust the transaction price to account
for other assets. For example, if a $50 million transaction
includes $5 million of value allocated to undeveloped acre-
age, the analyst would deduct the $5 million from the value
before calculating a $/BOE metric using proved reserves.
In order for the market comparables method to pro-
duce a meaningful estimate, the selected transactions must
closely match the property being valued. There are a variety
of reasons why two transactions may not be comparable,
including different geography (i.e., region or play), per-
centage of developed reserves, and mix of hydrocarbon
acquired (e.g., oil, natural gas). For example, a transaction
metric from a liquids-rich basin (i.e., a geological formation
Published in International Law News, Volume 44, Number 3, 2015. 2015 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion
thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
containing oil and gas reserves) would not be meaningful for
a property in a relatively gassy basin given the significantly
different mix of reserves. Selecting comparable transactions
requires a significant amount of judgment, and while ana-
lyzing many different data points can help to identify factors
that drive valuation, a few close comparable transactions
are better than many dissimilar transactions.
The primary advantage of the market comparables
method is that it can be used as a check on the income
approach as well as the discount rate applied. Specifically,
this method can be used to confirm that the $/BOE or
$/daily BOE metrics implied by a given discount rate are
consistent with other comparable transactions. For exam-
ple, if the metrics calculated based on a DCF valuation are
in line with the metrics for market transactions, this sug-
gests that the discount rate is reasonable. However, despite
this advantage, the market comparables method should
only be used as a check on the DCF approach and not as a
stand-alone valuation method. While the market compara-
bles approach can provide a quick approximation, the DCF
approach is superior because it utilizes factors (e.g., decline
curve, reserves mix, and oil and gas prices) that are specific
to the property being valued.
Acreage Pricing as a Common
Method to Value Undeveloped Reserves
Undeveloped reserves (i.e., proved undeveloped and
unproven reserves) can be difficult to value using the income
approach, particularly in areas where little development has
occurred and where not much is known about reserves and
production potential. Because undeveloped acreage has yet to
be de-risked, the lack of information needed to identify DCF
parameters can make the analysis highly speculative. Acre-
age pricing (a specific application of the market comparables
method) is an alternative that is commonly used by industry
practitioners to value undeveloped reserves. Acreage pricing
involves determining a $/acre price for contemporaneous
sales or leases of comparable plots of undeveloped land and
comparing it to the $/acre price of the transaction at issue.
Because of the different economic terms included in
acreage transactions, analysts using the market comparables
method must be careful to select transactions with similar
structures to the property being valued. A fee simple trans-
action involves the outright sale of the acreage and mineral
interests (e.g., oil and gas). A lease transaction is an agreement
by a mineral owner to lease mineral development rights to
a producer. In a lease transaction, the mineral rights owner
typically receives an upfront bonus payment (paid on a $/acre
27
 basis) and a royalty interest (i.e., a percent share of produc-
tion, excluding costs). The $/acre price used in the market
comparables approach should reflect the nature of the prop-
erty being valued (i.e., a sale or lease interest).
Because the comparable transactions should closely
match the property being valued, the analyst should also
consider different valuation drivers for acreage transactions.
The value of undeveloped acreage may be affected by:
Distance from existing production. Undeveloped acre-
age near already productive wells is generally more
valuable than unexplored acreage.
Acreage size and concentration. Buyers may be willing
to pay a premium to acquire larger, contiguous blocks
of land (especially if the buyer has adjacent acreage).
Production status. It is typical for mineral leases to
extend indefinitely as long as oil and gas is being pro-
duced in paying quantities on the leased property.
Such leases are said to be held by production. All
else equal, acreage held by production may be worth
more than acreage not held by production because of
the lessees lower renegotiation risk.
While the DCF method is the preferred valuation method
for proved developed reserves, the market comparables
method is often the preferred method for undeveloped
reserves. Because geological and reservoir data may not
exist for undeveloped acreage (i.e., potential reserves have
not been de-risked), the analyst may not be able to develop
cash flow projections for the subject property.
Conclusion
In essence, the oil and gas industry requires particu-
lar methodologies to value assets involved in litigation.
Those methods can be different depending on the types
of resources involved, their locations, the stage of develop-
ment of the resources, and the market risks associated with
development, production, and sales. u

The views expressed in this article are solely those of the authors, who are responsible
for the content, and do not necessarily represent the views of Cornerstone Research.

Published in International Law News, Volume 44, Number 3, 2015. 2015 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion
28 thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.