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The Valuation of Drilling and Exploration Rights in the Marcellus Shale Formation

Busines Valuation Update^{TM   Vol. 17, No. 6, June 2011}

By Joshua Lefcowitz, CPA/ABV/CFF, CVA, CFE, ASA, and Brandon J. Otis, CPA/ABV/CFF, CVA, CFE

Tom Ridge, the former governor of Pennsylvania, called the Marcellus Shale a “possibly unprecedented opportunity” in energy and economic development for small businesses, professionals, and ordinary workers.1 While the debate over hydraulic fracturing rock formations (“fracking” as it is regularly termed) and deep horizontal drilling is heated (one group sees a future of “carcinogenic vapors”2), it is unquestionable that the potential of the Marcellus Shale formation is significant. Published sources estimate approximately 50 trillion cubic feet of recoverable natural gas, or enough to supply the entire United States for two years, is available there—though the depth of the rock and its low permeability has made the Marcellus Shale an unconventional exploration target.

The formation’s close proximity (in PA, NY, OH, and WV) to high-demand markets in the Northeast United States has attracted national and international energy consortiums seeking to capitalize on an estimated $1 trillion in wellhead value. The drilling and exploration demand has created a boon—and complications—for landowners who are now forced to consider options of which they were previously unfamiliar. Those options, such as signing a lease, selling to a broker who conglomerates land, or passing their interests to the next generation, have many asking the fundamental question: “What are my Marcellus Shale rights worth?”

To answer these questions, we turn to the fundamentals of valuing intangible assets. It is widely recognized that for valuation purposes, assets can be generally categorized in one of four categories:

1. Tangible real estate
2. Intangible real property
3. Tangible personal property
4. Intangible personal property

The right to explore for and develop production of minerals, including those associated with the Marcellus Shale, is specifically categorized as of real property intangible assets which take the form of location-related exploration rights. As such, they would be valued in a manner similar to other intangible assets.

In many instances, the value of an intangible asset is created as a result of the future income that asset is likely to produce. Marcellus Shale rights are no different; however, there is substantial difficulty in determining what those future cash flows might be. In the case of a traditional well, a geologist may be able to determine the total amount of gas or oil under the surface of the ground. Natural gas contained in the Marcellus Shale, by contrast, is not directly determinable, due to its habitation within rock formations, which are not easily analyzed without actually fracturing. Nevertheless, it is clear, based upon production evidence, that significant quantities of natural gas lie below the surface within the Marcellus Shale formation.

Projecting Future Cash Flows

So, considering the difficulty in preparing a geological study, and without actual data on a particular piece of land, how can Marcellus Shale rights be valued? The answer lies in projecting future cash flows, using available data and analogous wells. In our experience, the key variables to projecting those future cash flows are:

1. Annual production—Annual production can be estimated based upon data from analogous wells. In our experience the two most important factors are:
   
   A. Where is the land located? The analyst needs to consider the fact that not all areas within the multi-state Marcellus Shale formation have the same amount of natural gas. Experience in the Barnett shale in Texas taught us that production amounts can vary drastically based upon location, and the same is proving true in the Marcellus Shale formation.
   
   B. What producers are working in the area in which the land is located? The analyst needs to consider whether all producers have the same proficiency in extracting the resource from the ground and whether those producers have the ability to extract the gas and deliver it to market.
2. Commodity price—What is the expected price of the natural gas commodity when it will be sold? The future world market for natural gas has a strong impact on the likelihood of drilling and the ultimate value of the gas when it is extracted and sold. A good resource such as New York Mercantile Exchange (“NYMEX”) pricing or forecasts provided by the United States Energy Information Administration in its Annual Energy Outlook study3 can provide this data.
3. Timing—When will the natural gas be extracted from the ground? This variable is not only dependent on the facts and circumstances of the specific project, but also upon the projected market. The analyst needs to consider:
   
   A. Where is the land located? The location of the land will have an impact on whether a producer will decide to drill, when he is likely to enter into a lease, and whether he will be able to deliver it to market.
   
   B. Is the land already under lease? If not, the analyst will need to make a reasonable estimate of when it would be able to be leased.
   
   C. What is the timeline for drilling activities for the area in which your subject land is located? Each producer has its own timetable to go from signing a lease to starting production. Consideration must be given to how long it will take the producer to start drilling activities.
4. Up-front cash consideration—Many leases provide for an up-front “bonus” payment. If the subject property is not yet under lease, the analyst needs to consider whether it is reasonable to include a provision for this potential cash in-flow.
5. Other items:
   
   A. Expenses—The analyst needs to consider if the landowner has any expenses associated with generating this cash flow. If there are annual expenses and/or remediation costs not to be paid by the producer, the analyst should include those items.
   
   B. Contributory asset charges—If there are tangible assets that contribute to the generation of the cash flows, consideration of relevant contributory asset charges is necessary.
6. Discount rate—A prospective buyer of the subject asset would require a rate of return on its investment commensurate with the degree of risk associated with the investment. This variable is heavily dependent on the facts and circumstances of the specific engagement.
   
   In general, many of these variables can be calculated based on the facts and circumstances in the particular case and using publicly available information. Nevertheless each variable must be considered, analyzed, and often discussed with the owner of the property.
   
   Annual production is one factor that is difficult to calculate. For purposes of quantifying well production in Pennsylvania, we utilize as a resource Well Production Reports, which must be submitted by all producers in the state for each well they operate. The data can be found on the Pennsylvania Department of Environmental Protection (“PADEP”) web site.4
   
   

   Beware of utilizing the raw data provided by the PADEP without detailed analysis. Experience has taught us that there are a number of discrepancies in the data, which can be accounted for but need to be appropriately examined and adjusted. The data obtained here can provide excellent direct comparisons to a subject well, but requires a significant amount of analysis and scrutiny.

Concluding Remarks

Performing an analysis on Marcellus Shale interests can be extremely complicated and requires a delicate balance of making reasonable assumptions and usage of the information known as of the date of your appraisal. Nevertheless, projecting cash flows within a reasonable degree of economic certainty is possible. For those considering transactions involving shale interests, that projection and a valuation of the cash flows are advisable. For owners considering a gift or trustees administering an estate, that valuation is imperative. A careful analysis of each factor can provide those involved in Marcellus Shale transactions a well thought out, defendable, estimate of value.

Joshua Lefcowitz, senior manager of the Business Valuation & Litigation Support Services group at Alpern Rosenthal, can be reached at jlefcowitz@alpern.com. Brandon J. Otis, manager of the Business Valuation & Litigation Support Services group at Alpern Rosenthal, can be reached at botis@alpern.com.

 

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1. Stuhldreher, Tim, “Ridge promotes Marcellus Shale in NFIB call.” Central Penn Business Journal, April 19, 2011.
2. Matthews, Cara, “Hundreds attend rally to bar drilling.” Democrat and Chronicle, Albany Bureau, April 12, 2011.
3. www.eia.gov/forecasts/aeo/.
4. https://www.paoilandgasreporting.state.pa.us/login.aspx?ReturnUrl=%2f. This web site requires a password to log in.

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Business Valuation Update June 2011
Reprinted with permissions from Business Valuation Resources, LLC

 The Valuation of Drilling and Exploration Rights in the Marcellus Shale Formation - PDF