Valuation

"What was the commodity price you used for your valuation?"

"I think our valuation is wrong,” I announced breathlessly.

How else to explain the different metrics from my model compared to a press release on the acquisition of an upstream oil asset in the Rocky Mountains?

A recent hire, I had rushed into my manager’s office to explain my concern. Before sharing my panic, he asked some questions.

“What was the commodity price you used for your valuation?” Then, “What was the acreage position?” And, “Is the oil production curve you used the same as the one used by the companies that bought and sold the asset?”

And many more. Slowly, but surely, it dawned on me. My valuation model wasn’t wrong.

It was just different!

Time and again, I’ve had to face similar situations. A comment I hear often — mostly from those who don’t work directly on asset valuations — is, “This analysis is completely incorrect.” I’ve also found that most of the time there’s a logical explanation for differences. Most analyses can be validated. So why are these comments so prevalent?

It all boils down to this conundrum: Is valuation a science, with well-defined steps and consistent processes? Or is it an art, reflecting the insights and choices a skilled analyst brings to bear?

To analyze an upstream, onshore, oil-producing asset, I need a set of facts, including acreage position and capital to be invested. These facts become part of the set structure within the valuation models. Then I have to build out the asset development plans and estimate costs. These inputs are assumptions, and may be challenged.

Imagine the number of factors involved in a single metric: such as commodity prices. A commodity price analyst, frustrated by market volatility, might say, “Over the past several quarters, we have not been able to come up with a forecast that has reflected actual price movements, even though we have spent countless hours analyzing it.” This ambiguity can be driven by multiple factors, all the way from the economic health of the country down to the individual user at the pump. And this is just one of the assumptions used in an asset valuation model.

Recently, the valuation for one of our assets was on the lower side of that provided in the asset deal announcement. We double-checked the analysis. The facts were accurate. Assumptions on metrics, such as cost estimates, were in place as well. By simply making our forecast more aggressive, we found that we could match the valuations provided in the deal announcement.

“I think our valuation model is wrong, and I don’t know why,” my newest team member told me. He had followed the steps exactly as he’d learned them. His inputs were complete. He had gone over the process in his mind multiple times and was distressed that it was not giving him the results he wanted.

Smiling to myself, I asked him, “What was the commodity price you used for your valuation?”

Siddhartha Sen is a 2009 Jones Graduate School of Business alumnus currently working at IHS Markit. He has more than 10 years of asset valuation experience.