Introduction
The decision to make investments in oil or gas reserves is determined by therelationship between the value of a barrel in-ground and the cost of creating anew one. Wide disparities between these two values will result in investment ordisinvestment until the in ground value is equal to the cost ofreplacement.
Over the past few years there have been several mergers and acquisitions inthe domestic oil and gas industry. Some of these mergers have include thepurchase of large quantities of proven reserves at prices that were deemed tobe low in relation to the development cost of the reserves. This is evidencedin the oft-repeated saying that “it is cheaper to buy oil on Wall Streetthan by drilling”. If so, the price of the asset oil in the ground is muchless than its cost. It is difficult to see why sellers insist on giving awayassets, year after year. The implication is that the capital market isinefficient, a proposition worth testing. In this paper we examine the marketvalue of reserves to test this paper we examine the market value of reserves totest this proposition. proposition.
ESTIMATION OF MARKET VALUE OF RESERVES
When analyzing the recent sales of oil and gas properties to determine themarket value of in-ground reserves, it is common practice to combine oil andgas into a value per “barrel of oil equivalent“. The rationale behindsuch an approach is that the value of 6 million Btu of gas is equal to a barrelof oil. As we demonstrate below, value per barrel of oil equivalents aremeaningless, because combining oil and gas reserves is akin to adding applesand oranges. The value of 6 million btu of gas may, in some uses, exceed thevalue of a barrel of oil. However, the most valuable use of crude oil isrefining it into light products, to the point where an increment of processingwould just equal the increment of value. Hence, even at the point ofconsumption, we would expect oil to be worth more. Because the transport costof gas is several times that of oil, its field price will probably be muchlower. It is entirely a matter of local supply and demand.
The inadequacy of the “oil equivalent” approach is clearlydemonstrated by examining the historical relationship between oil and gasprices. Figure 1 shows the ratio between oil price to the gas price in theTexas-Louisiana region for two widely separated periods free of regulation. Inthe fourteen years after World War II, the price of oil ranged between 3 and 9times the gas thermal price of oil ranged between 3 and 9 times the gas thermalequivalent. The drop in the ratio during the period 1948-58 resulted from thefirst great wave of gas pipeline construction, which greatly increased demandfor gas by bringing it to all parts of the country. In the late 1980s, theoil:gas price ratio was stable around 1.5 times the gas thermal equivalent, butit could go higher or lower. In theory and experience, “barrel of oilequivalent” makes no sense.
A different problem arises in the kind of plot one sees in the financialliterature, where the “replacement ratio” (reserves-added/production)is drawn on the vertical axis and the cost per unit(expenditures/reserves-added) on the horizontal. The idea is correct: the moreefficient the company, the more they should be able to replace profitably.Unfortunately, with reserves-added on both sides profitably. Unfortunately,with reserves-added on both sides of the equation, the result isforeordained–and meaningless.
