?How are upstream oil and gas assets being valued in the current market environment? What multiples will these assets command today?

In 2007 and throughout most of 2008, one could have glanced back six to 12 months and found several comparable A&D transactions, or “comps,” to gain a realistic perspective on what the market would yield for properties offered for sale. Buyers, sellers and advisors could have meaningful conversations about asset value, with significant transaction data to back up their arguments.

Over the last several months, however, A&D activity has fallen off a cliff, and conversations about value are less likely to reach consensus.

Valuing recent deals. Two recent transactions—the sale of Berry Petroleum’s Denver-Julesburg Basin assets, and the purchase and privatization of Legacy Reserves LP—offer hints of the market’s current state. Each of these transactions traded at levels significantly lower than would have been projected based on historical upstream A&D transactions as well as Energy Spectrum Advisors’ (ESA) R/P valuation tool. This valuation tool is based on a historically strong correlation between a property’s R/P value and an asset’s sales value per unit of daily production.

The graphs show this correlation as it pertains to all of the closed majority oil and gas transactions for the trailing 12-month period ending March 31. A majority of these transactions occurred in the second and third quarters of 2008. The lack of closed transactions during the last six to eight months, sparked by the recent lack of interest or ability on the part of publicly traded companies to buy oil and gas assets, as well as by the subsequent 40% to 70% step-change reduction in valuation, has negatively impacted the effectiveness and accuracy of ESA’s R/P valuation tool.

However, comparing the recent Berry and Legacy deal metrics to historical valuation multiples over the past 12 months helps show how drastically times have changed relative to asset valuations.

Berry’s discount. On March 3, Berry Petroleum announced an agreement to sell its upstream Denver-Julesburg assets for $140 million. At the end of 2008, net production from the properties averaged 18 million cubic feet equivalent per day, while proved reserves totaled 126 billion cubic feet equivalent. The calculated proved R/P (or pseudo reserve life) was just over 19 years. This deal traded for $1.11 per thousand cubic feet equivalent (Mcfe) in the ground and $7,778 per Mcfe of net daily production.

Using the R/P valuation tool, which again is based primarily on closed transactions over the past 12 months, ESA would have projected the deal to trade for approximately $365 million, or more than $20,000 per flowing Mcf. In other words, this deal traded at a 60% discount relative to what would have been predicted just nine to 12 months ago.

Despite the fact that Legacy’s properties are predominantly proved developed producing (PDP), the Berry and Legacy deals were valued similarly.

Legacy’s sale. On April 3, New York-based private-equity firm Apollo Management made an offer to acquire and take Legacy private for $435 million. At the end of 2008, Legacy’s net production averaged 8,553 barrels of oil equivalent (BOE) per day, while proved reserves totaled 30.8 million BOE. The calculated R/P was approximately 10 years. This deal was valued at $14.10 per BOE in the ground and $50,859 per BOE of daily production.

Using the valuation tool, ESA would have projected the deal to trade for approximately $792 million, or more than $92,000 per BOE per day. As in Berry’s case, if this deal is approved, it will trade at a 45% discount relative to historical transactions.

In short, yesterday’s valuations no longer apply to tomorrow’s.

Given the dramatic decline in commodity prices and the ongoing credit crisis, today’s buyers have a newfound appreciation for risk. The market enjoyed riding the energy wave over the last couple of years but perhaps forgot bad things can happen—and quickly—in the oil and gas industry.

Upside for free. Buyers once contemplating how much value to place on 2P (proved plus probable) and 3P (proved, probable and possible) reserves are now contemplating how much they can pay for PDP reserves and still receive upside for free. There has been little, if any, value offered by buyers for undeveloped reserves (proved and unproved), as recent transactions are suggesting valuations 50% to 70% lower than similar transactions from six to eight months ago.

A return to fundamental, risk-adjusted cash-flow analysis now appears to be the rule as hurdle rates of return, driven even higher by higher capital costs, cannot be achieved in most cases given current and projected commodity prices and development costs. If buyers cannot expect to achieve a reasonable rate of return for themselves and their capital partners, then little or no value will be offered for undeveloped reserves.

Energy stocks are being hammered as the marketplace isn’t generally giving public companies credit for their 3P reserves. As a result, there has been a reduction in public companies’ arbitrage potential associated with buying properties through private auction transactions and subsequently realizing a retail benefit in the public marketplace. This lack of arbitrage potential currently is a disincentive to public companies to aggressively pursue acquisition opportunities.
—B.J. Brandenberger, Energy Spectrum Advisors Inc.
(energyspectrumadvisors.com)