The American Institute of Business Law In conjunction with The Oklahoma Bar Review and The Conference on Consumer Finance Law VALUING OIL & GAS ASSETS IN THE COURTROOM By: RHETT G. CAMPBELL (c) 2002 THOMPSON & KNIGHT, LLP 1200 Smith, Suite 3600 Houston, Texas 77002 Email: reampbell@tklaw.com February 7-8, 2002 Renaissance Hotel Dallas, TexasMm. VALUING OIL & GAS ASSETS IN THE COURTROOM By: RHETT G. CAMPBELL (¢) 2002 THOMPSON & KNIGHT, LLP 1200 Smith, Suite 3600 Houston, Texas 77002 Tele: 713.653.8660 Fax: 832.397.8260 Email: reampbell@tklaw.com TABLE OF CONTENTS Introduction, Substantive Issues in the Methodology of Valuation of Oil and Gas Assets. A. The Nuts and Bolts of Valuing Oil and Gas Asset on B. The Correct Definition of “Fair Market Value. C. The Reservoir Report. (1) Classification of Reserves. (2) Pricing Assumptions. 3) The Discount Rate. (4) The Risk Factors. (5) __ Probabilistic versus deterministic methodologies. D. The Reserve Engineer's Method of Determining Fair Market Value. 14 (1) Comparable Sales Method. 15 (2) Rule of Thumb Methods. 16 (3) Income Forecast Methods. 18 4) 2 (5) we 22 E, The Financial Expert's Method of Valuing Oil and Gas Asset 2B Qualification of Expert Witnesses in Valuation Trial A (1) The Discounted Cash Flow Approach, 2B (2) The Transaction Approach... (3) The Market Approach... @ The Party with the Burden of Persuasion Must Offer Expert Witness Evidence that Satisfies the Daubert Requirements for Admissibility. qd) The Methodology Used by the Witness to Determine FMV must be Acceptable and Reliable : . Q) A Reserve Report is Not “Fair Market Value”.. (3) The Expert Witness Must be Qualified by Experience and Training to Render an Opinion as to Fair Market Value of Oil and Gas Assets, (4) The Expert's Opinion on FMV Ought to be Internally Consistent. (5) The FMV Opinion Must be Based Only on Data that is Available to Buyers and Sellers in the Market Place. - iB. The Expert Must Tender a Report that Satisfies the Requirements of Rule 26(a)(2)(B), FED. R. Cv. P. (1) Rule 26(a)(2)(B) Requires a Written Report Containing the Basis for the 34 34 3) s Exclusion of Evidence that does not Comply with 35 (3) The Expert Report Must Include an Explanation of the Bass forthe Opinion of Val 36 36 37 37 37 37 IV. Conclusion. V. Bibliography ‘A. Books and Treatises. B. Published Articles.. C. Papers and Presentation: iiVALUING OIL & GAS ASSETS IN THE COURTROOM I Introduction. "{Ofil and gas financing is a strange world of its own.’ Woodward v. Wright, 266 F.2d 108, 155 (10th Cir. 1959). In attempting to convert dreams of black gold to hard cash, aspiring capitalists split the property interests in oil into 'more fragments than the atom or the rainbow.' citing B. Clark, The Law of Secured Transactions Under the UCC (2d ed. 1988).1 Companies in the oil and gas industry are uniquely susceptible to commercial disputes and litigation. This is inherent in industries that are capital intensive, high-risk, high-reward, and where field operations are physically dangerous. Additionally, the energy industry has always been plagued by business cycles caused largely by volatile commodity prices. Based upon depleting assets, companies engaged in exploration, development and production of oil and gas have unique problems for the practitioner. As a result, the energy industry often poses unexpected challenges for the oil and gas attorney forced to deal with valuation of oil and gas assets. We address some of those problems and challenges in this paper. Determining the value of oil and gas properties is a continuing problem in litigation. There are a number of issues to be addressed in considering the value of oil and gas assets. Primary among these are (1) substantive issues relating to the methodology of valuing oil and gas assets; and (2) evidentiary issues. We will consider these in turn. ' Jones v. Salem National Bank (In re Fullop), 6 F.3d 422 (7th Cir. 1993). ‘THOMPSON & KNIGHT, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 Houston, Texas 77002 Teles AS48111 Fee: 7136841 Web: woewaidaw.comIl. Substantive Issues in the Methodology of Valuation of Oil and Gas Assets. A. The Nuts and Bolts of Valuing Oil and Gas Assets. ‘The most common type of oil and gas property is the working interest in oil and gas in place. Although there are other types of interests that present slightly unique challenges, the basic method of determining fair market value of an undivided interest in oil and gas reserves “in place” is the starting point for valuing other, related interests. We will deal with valuing the working interest.? B. The Correct Definition of “Fair Market Value.” The threshold issue is the proper legal definition of “fair market value.” Fair market value or market value is the subject of various definitions, though all are simply variations on a theme: a willing buyer, a willing seller, neither under compulsion, and both with knowledge relevant to the market place. Fair market value is the cash price that a willing buyer would pay to a willing seller for the property in its existing state, under prevailing market conditions at the time that the evaluation is made.” The market value of an article or piece of property is the price which it might be expected to bring if offered for sale in a fair market; not the price which might be obtained on a sale at public auction, or a sale forced by the necessities of the owner, but such a price as would be fixed b negotiation and mutual agreement, after ample time to find a purchaser, as between a vendor who is willing (but not compelled) to sell and a purchaser who desires to buy but is not compelled to take the particular article or piece of property.* ?The “working interest” is the cost sharing interest in the property. 'F, Allen, and R. Seba, ECONOMICS OF WORLDWIDE PETROLEUM PRODUCTION (Oil & Gas Consultants, International, Inc.: Tulsa, Oklahoma, 1993) p. 430. “BLACK's Law DICTIONARY (1910 ed.) p. 761, quoted with approval in R. Hughes, OIL PROPERTY VALUATION (New York: 1978) p. 62. ‘Thomson & KNIGHT, LLP ATTORNEYS & COUNSELORS 1200 Smith Steet, Suite 3600 Houston, Texas 77002 ‘Tele 136548111Market value - The most probable price in terms of money which a property should bring in competitive and open market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus.* For purposes of estate, gift and income taxes, fair market value is “the price at which the property would change hands between a wiling buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts."° The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell afier reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self- interest, and assuming that neither is under duress.” The identical definition is contained in THE DICTIONARY OF REAL ESTATE APPRAISAL (Appraisal Institute, 3rd ed. 1993) p. 222. A key and integral part of any definition is the knowledge of the market place imputed to both a theoretical buyer and a theoretical seller. Included within this definition is the requirement that the expert witness's opinion must not utilize data not reasonably available to the market place on the value date. If the witness does so, his opinion is generally neither reliable nor admissible. C. The Reserve Report. ‘The starting point for any valuation estimate is prepared by the petroleum engineer who must estimate the quantity and nature of hydrocarbons in the ground, how quickly they can be recovered, SI, Baton, REAL ESTATE VALUATION IN LITIGATION (American Institute of Real Estate Appraisers: Chicago, Ilinois, 1982) p. 5. SIRS Reg. Sec. 20.2031-1(b); Atlantic Richfield Co. v. Farm Credit Bank of Wichita, 226 F.3d 1138, 1166 (10 Cir. 2000); quoted in G. Desmond and R. Kelley, BUSINESS VALUATION HANDBOOK (Valuation Press, Inc.: Los Angeles, California 1988), p. 248. "THE APPRAISAL OF REAL ESTATE (Appraisal Institute, 10" ed. 1992) p. 20. 713.6548101 Fax: 713684871 rota.‘what percentage can be recovered, the cost of recovery, and the present value of the net cash flow using various discount rates, usually centering on 10%.* This is the reserve report. The Society of Petroleum Evaluation Engineers has established a web site at which the public can view a draft? “Recommended Evaluation Practice” in which the SPEE states (currently in draft form only) those items that should be contained in a typical reserve report. In the reserve report, the petroleum engineer (usually a reservoir engineer) should estimate, based on the best data available, the classification and quantity of reserves that can be recovered over time. Typically, the reservoir engineer will apply assumed prices into the future in order to “monetize” those reserves into a cash flow table. The engineer may, or may not, be qualified to opine as to the likelihood and reasonableness of the pricing assumptions: often the engineer simply uses the pricing assumptions requested by the client. The engineer should determine the cost of recovery, including capital expenditures and lease operating expense, as well as estimate (or rely on someone else's estimate of) the commodity prices over the recovery period. * Forrest A. Garb & Gerry L. Smith, “Estimation of Oil and Gas Reserves,” Chapter 40, p.40-1, found in HOWARD B. BRADLEY (ed.), PETROLEUM ENGINEERING HANDBOOK (Society of Petroleum Engineers: 1987). ° http://www.spee.org/rep_pdfs/rep01.pdf "Tomson & Kwicur, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600(Clas ion of Reserves In estimating reserves, the reservoir engineer should give quantities of recoverable reserves within various classifications, generally proved, probable and possible. The category of proved reserves is generally broken down, at a minimum, into proved developed producing ("PDP"), proved non-producing (“PDNP"), and proved undeveloped ("PUD"). The categories of proved reserves are the most important for our purpose because (1) lenders will generally loan on the basis of collateral that is classified as “proved” only, and (2) a purchaser will usually pay for proved reserves only. (This is not to say that probable and possible reserves are not important; they are. The probable and possible are the “sex appeal” of a property and may determine how determined a bidder is to buy the property in question. ‘Thus probable and possible affect market value by attracting bidders and keeping them attracted. Nonetheless it remains true that lenders certainly loan and bidders bid pretty much on the basis of proved reserves.) Proved non-producing are often broken down into further categories, being proved behind pipe (“PBP*) and proved developed non-producing (“PDNP"). In laymen’s terms, the categories of reserves are basically these: 1. Proved developed producing ("PDP*) are those where the well is completed and the reserves are currently being produced. This is the most valuable category because (1) pressure and production data are readily available and generally accurate, and (2) cash is being generated regularly by production. 2. Proved developed non-producing (“PDNP") are reserves where the well-bore exists and the reserves are identified but for some reason are not currently producing, whether shut-in for lack of market or for mechanical reasons. In this category, the reserves can be produced by either turning on production or accomplishing a mechanical repair operation. The significance of this “THOMPSON & KNIGHT, LLP ATTORNEYS & COUNSELORS ‘Teer T3.6848111 Fax: 7136844871 Webs wwwthlaw.comcategory is that no additional capital expenditure is required to complete a new formation and, thus, there is less risk than in proved behind-pipe. 3. Proved behind-pipe (*PBP") reserves are those where a reservoir different from one currently producing has been identified. However, because the operator must plug off the current zone and recomplete ina different zone (usually higher up, i¢., closer to the surface), there is greater risk that the reserves may not be recoverable. 4, Proved undeveloped (“PUD”) are the lowest category of proved reserves and the least valuable because a new well is required to be drilled and completed, with accompanying risk, in order to recover the value. These reserves require the most capital investment and the greatest risk (among proved reserves) in order to exploit them. The definitions of proved reserves are established by the Society of Petroleum Engineers,” the World Petroleum Congress," the American Association of Petroleum Geologists,"? the American Petroleum Institute," and the Society of Petroleum Evaluation Engineers.'* The Securities and Exchange Commission has its own set of definitions, though the only essential difference is that of holding prices constant (no increase based on estimated future conditions) but allowing escalation of prices based upon existing contracts, if any. '* Once © Found as Appendix D to Monocrapi I (2d ed.), “Guidelines for Application of Petroleum Reserves Definitions,” The Society of Petroleum Evaluation Engineers (October, 1998). The web page for the Society of Petroleum Engineers is http://www.spee.org/. "http://www.world-petroleum.org/ http://www.aapg.org/indexaapg. html Shttp/wwwapi.org/ “thttp://www.spec.org/ 'S SEC SX Rule 4-10, found as Appendix A to MonoarapH I (2d ed.), “Guidelines “Tuomrson & KnIGur, LLP ATTORNEYS & COUNSELORS 1200 Smith Steet, Suit 3600 Houston, Texas 77002 “Teles 746848111the reservoir engineer has determined what he believes to be the recoverable reserves based upon the best available data, he then aggregates that data by well, by field, by property, and then totals them all. The presentation is in a format so that the user can make his own assumptions as to prices and applicable discount rates. In the reserve report, the reservoir engineer will assume certain commodity prices at various points in time and then estimate the future net revenue (“FNR") over the life of each property, classifying each as PDP, PDNP, PBP, or PUD as appropriate. Each property (within each category) will be discounted to present value using various discount rates, typically ranging from about 6% to perhaps 18%. The reserve report, and the FNR at various discount rates, is the base data from which a qualified valuation expert can then determine the fair market value of the property. Several good sources for learning more about the estimation of oil and gas reserves and the calculation of FNR are: Forrest A. Garb & Gerry L. Smith, “Estimation of Oil and Gas Reserves," Chapter 40, p.40-1, found in HOWARD B. BRADLEY (ed.), PETROLEUM ENGINEERING HANDBOOK (Society of Petroleum Engineers: 1987); and MonocRraPH I (2d ed.), “Guidelines for Application of Petroleum Reserves Definitions,” The Society of Petroleum Evaluation Engineers (October, 1998). Itis extremely important for lawyers and other professionals dealing with reserve reports to recognize that the report is not a determination of fair market value. Although Generally Accepted Accounting Principles, as modified by the SEC rules, require companies to report reserves based on the lower of cost or PV10 of proved reserves, is essential to understand that such number is not for Application of Petroleum Reserves Definitions,” The Society of Petroleum Evaluation Engineers (October, 1998). “THomsow & KNIGHT, LLP ATTORNEYS & COUNSELORS Web: woewathlaw.comfair market value. The reserve report is the base data upon which any FMV calculation must be based but the report, itself, is not a determination of FMV. 2) Pricing Assumptions. Any valuation expert who has a copy of the reserve report can plug in his own pricing assumptions over the life of the property (called the “price deck”) and calculate the FNR. At different prices over different periods of time, of course, the FNR will be different. Prices are one of the most important variables. Estimating future commodity prices is uncertain at best. Atany given date and time, the New York Mercantile Exchange (“NYMEX")'* quotes prices for futures contracts for oil and gas about 36 months into the future. Pulling each of these future months together at a given date yields the “strip” for that date and indicates with precision what the “market""” believes prices will do in the future. Even the New York Mercantile strip is, of course, nothing more than the aggregate estimates of those in the market at any given point in time, Other companies publish newsletters showing what parties are paying for futures contracts for commodity prices and what parties in the market believe prices will do into the future. Madison Energy Advisors, Inc.'* publishes one such service," whose estimate of future prices often is relied upon by valuation 'Shttp://www.nymex.com/ '’ The “market” in this sense is nothing more than the aggregate opinion of all buyers and sellers ata single point in time. If one believes in the “invisible hand” theory of markets, then the NYMEX strip is the best estimate of future prices. However, it must also be recognized that at any given moment, many extemal forces, including political, psychological, and the economic desirability of alternative investments, enter into the market's pricing. att /www.madisonenergy.comv/home.cfm 'http://downloads.pennnet.com/ogjpe/reports/qpp.pdf “THOMPSON & Kx, LLP ATTORNEYS & COUNSELORS 1200 Smith Steet, Suite 3600,experts. Randall & Dewey” also publishes a pricing survey, located on its web site,”' as does Credit Lyonnais Securities.” There are other similar sources of future prices. In the final analysis, the expert's opinion of future prices is no better and no worse than the underlying assumptions and, depending on actual events, could be correct or wildly wrong, Needless to say, the pricing assumptions are always a critical issue when considering the valuation opinion of an expert witness who is opining as to the market value of oil and gas properties. Price hedges. Hedges have become an increasingly important and ubiquitous feature of energy economics. A hedge, per the SPEE, is a contract for the future purchase or sale of quantities of oil or gas at a pre- determined price and where the holder of the contract has the right but not the obligation of physical delivery.” The SPEE has proposed a Recommended Evaluation Practice to address hedges and their impact on the fair market value of an oil and gas property.”* In brief, the SPEE takes no position on. whether a hedge should be included in the FMV evaluation or not, only that the report should clearly state when it is included in the evaluation, and, if included, the preparer should include a separate cash flow forecast for the hedge position. The report should also state whether the hedge position is property specific or not. The important point to note is that the FMV of the property can exist ?http://www.randew.com/ http://www.randew.com/research/QAR/price.htm http://www.emgmkts.com http://www.spee.org/tep_pdfs/rep04.pdf "Id. ‘THoMson & KNIGHT, LLP ATTORNEYS & COUNSELORS 1200 Smith Steet, Suite 3600, Houston, Texas 7002 “Tele: T46548111 ‘Webs wo law: comindependently of a hedge position or, alternatively, it can have a different value (greater or lesser) if the hedge accompanies the property. (3) The Discount Rate. In determining present value of the net cash flow, it is necessary to discount the FNR at an appropriate discount rate. What discount rate is correct depends on many factors, including a particular company’s cost of funds and desired internal rate of return. The SEC requires the use of 10% in filings for public reporting companies. (4) The Risk Factors. Most experts who value oil and gas reserves do so on the basis of proved producing reserves. ‘A currently producing property has a certain history and a reasonably certain future (at least it as certain as anything can be in the oil and gas industry). Valuing PDP reserves is well-understood and the methodology can be applied with reasonable accuracy to other disciplines in comparing investments and determining value. However, PDNP, PBP, and PUD reserves are much more difficult to value because the uncertainty is greater, and the degree of uncertainty is often difficult to know. ‘Thus, evaluation experts apply “risk factors" to tum PDNP, PBP and PUD reserves into “pseudo-PDP reserves.” These risk factors are sometimes called “discount factors" but they must not be confused with the discount rate used to discount cash flow back to present value. ‘These risk factors are intended to take into account the mechanical and reserve risk associated with reserves that are not current online and producing. When reaching a value conclusion for the FMV of PDNP, PBP and PUD reserves, it is essential to know whether the reserves have been “risked” or not, that is, whether the DNFR have ‘THOMPSON & KMONT, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 Ho 10been risk-adjusted. Only after such risk-adjustment should the result be added to the DNER of the PDP reserves and that aggregate total then used to determine the FMV of the property. ‘The proper “risk factor” to use for such adjustment isa critical piece of the FMV puzzle. The “correct” risk factors would be those used by buyers and sellers in the market place at a given point in time. Typically, only an expert with knowledge of the market and experienced in buying and selling properties would have sufficient experience to exercise judgment and determine the correct risk factors. A common source of “risk factors” is the Annual Survey of the Society of Petroleum Evaluation Engineers (“SPI . In the most recent survey, June, 2001, the SPEE tabulated 149 responses and averaged the results. Within the industry, it is common for valuation experts to use the results of the SPE survey as a source for risk factors. Based on the June, 2001 Survey, considering all respondents, 53% applied risk to discounted cash flows, whereas 47% applied risk factor prior to performing a cash flow analysis. Breaking it down by category of respondent, a minority of the producers (those engaged in oil and gas production and thus those parties who buy and sell properties) responding to the survey (26% out of 54%) applied the risk factors to reserve volumes before performing a cash flow analysis, with the majority applying the risk factors to discounted cash flow (28% out of 54%). Bankers lending on oil and gas properties were evenly split (6% out of 12% each way). Consultants tracked producers, with 19% out of 34% applying the risk factors to discounted cash flow and 15% out of 34% using pre~ discounted cash flow.’ In considering acquisitions, which is the market for buying and selling properties, the risk factors reported in the most recent SPEE Survey were as follows: ‘TwoMrsox & KniGnt, LLP ATTORNEYS & COUNSELORS 1200 Sith treet, Sute 3600 Houston, Texas 7002 Teles 46848111 Fax: 713.656.1871 ‘Webs ww hlaw.com ittTABLE 2 Median Average PDP 100% 97.2% PDNP* 85% 80.8% PBP 75% 2% PUD 50% 52% *Proved Shut-in, ‘What Table 2 shows is that if the sample is representative of the universe of those who buy and sell properties, and if the responses are an accurate statement of what buyers and sellers in the market actually use to determine the price of properties that are bought and sold, then PUD reserves are typically “risked” at 50% to achieve a DFNR that is then added to PDP reserves (and other reserves) in order to determine FMV. Touse an example, a calculation of FMV using PV15 as sole criteria of value might yield the following tabl TABLE3 Reserve Category DNFR @ 15% Risk Factor FMV PDP $ 79.091 mm. 100% $ 79.091 mm PDNP $ 20.413 mm 80% $ 16330mm, PuD $ 18.717 mm 50% $ 9358 mm Total proved $118.22 mm $104,779 mm In Table 3, the evaluator has taken the base reserve report and considered the PV15 numbers (shown on the table as DNFR @ 15%), applied risk factors of 100% to PDP, 80% to PDNP, and ‘50% to PUD reserves, and concluded that the FMV of the properties in the aggregate is $104.78 million. This is a simplistic but effective method of calculating fair market value of oil and gas properties and demonstrates the use of “risk factors.” (5) _ Probabilistic versus deterministic methodologies. 25 SPEE Survey 2001, p. 24. THOMPSON & KNIGHT, LLP [ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 Hosston, Texas 7002 ‘Teles TER6S48111 Fax: 7136844871 12The method of determining reserves described above is generally considered the “deterministic” method because it yields a final value conclusion. This is the method traditionally advocated by the Society of Petroleum Engineers and the World Petroleum Congress. The Society of Petroleum Evaluation Engineers, on the other hand, has addressed different levels of uncertainty in categories of reserves and has moved more towards probability in its philosophy. Both methods recognize uncertainty and deal with it but the SPE probabilistic methods attempt to recognize uncertainty and reflect that reality in giving ranges rather than specific values. In brief, a probabilistic method would reflect the following categories of reserves: P1 — being 90% confidence that proved reserves will equal or exceed this value; P2 — being 50% confidence that proved plus probable reserves will equal or exceed this level; and P3 — 10% confidence that proved plus probable plus possible will equal or exceed this level.” Because the deterministic method yields a specific number (albeit risk adjusted) that represents the “single best estimate of reserves” based on known data,”* whereas probabilistic focuses on a range of probabilities, it is almost impossible to compare the two types of methods. Additionally, probabilistic estimates cannot be simply summed arithmetically to arrive at a total if the integrity of the confidence level is to be maintained.” The attraction of the probabilistic method is the recognition that reserve estimation is, afterall, an estimate and uncertainty is inherent in the process. Given that fact, a range of probabilities is more likely closer to the truth than a 26 SPEE Monograph I, p. 23. 7 Id, p.25. 28 SPEE 2001 Survey, p. 12. 2° SPEE Monograph I (2d ed.), p. 27. ‘TwoMrson & Know, LLP ATTONNEYS & COUNSELORS 1200 Smith Street, Suite 3600 Houston, Texas 7002 “Tee: 16848111 Fax: 7136844871 Webs wwthlaw.com 1Bdeterministic conclusion. However, the deterministic conclusion yields a number that is easier to deal with and more objective in its outcome. Also, itis inherently true that the larger the number of properties and fields that are summed, the greater the confidence that the deterministic method will yield a correct conclusion. A sum of “reasonably confident” numbers yields a number in which there is greater confidence than the numbers summmed.”° The June, 2001, SPEE Survey learned that out of 149 respondents, 37.2% used the probabilistic method of estimating reserves, down from 43.2% in 2000. Only 24% said they used probabilistic methods every time it was possible to do so (where data and budget were available). D. The Reserve Engineer’s Method of Determining Fair Market Value, ‘There are a number of ways to calculate FMV of oil and gas properties. Garb suggests there are four basic methods of determining FMV of an oil and gas property: (1) comparative sales; (2) rule of thumb; (3) income forecast, and (4) replacement cost.’' Garb points out that there are many uncertainties in arriving at a FMV conclusion for energy properties, including technological, economical and political concerns. The SPEE 2001 Survey inquired, for the first time, as to the respondents’ preferred method for determining value of oil and gas properties. In the response, the Discounted Cash Flow method (which is a subset of the income forecast as described by Garb) was the overwhelming favorite, at 86%. Comparable sales was preferred by 1%, and no other got more than 5% preference.” 30 1, *'Rorrest A. Garb, “Which Fair-Market-Value Method Should You Use?" January, 1990 JOURNAL OF PETROLEUM TECHNOLOGY, p. 8 (1990) (hereafter “Garb"). >? SPEE 2001 Survey, p. 14. ‘THoMson & KNIGHT, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 Houston, Texas 7002 ‘Tele: TH36548111 14The technological uncertainty is the possibility that the reserves might not be recovered in the amounts or at the rates forecast. The economic uncertainties include (1) future oil and gas (commodity) prices, (2) market conditions, (3) future operating costs, and (4) the potential need for additional capital expenditures. Political uncertainties include (1) oil-import quotas, (2) taxation, (3) environmental considerations, (4) nationalization (outside the U.S.), (5) required sale of products in ‘the host country, and (6) capital repatriation restrictions.”* (1) Comparable Sales Method. This method, of course, compares this property to other similar properties that have recently sold in the market place. There are numerous problems with this method: (1) properties are not {identical and are more often different than alike. (2) A proposed “comparable” transaction may have been driven by external considerations (other than the market place) that are difficult to understand ‘or quantify. If the “comparable” sale was at auction, it may have been unrealistically high due to an irresponsible bidder (the “greater fool"). ‘There are so many variables in oil and gas production, not all of which are related to the reserves, that unless the comparable property is studied as completely as the one being purchased, errors can be made with this technique.** However, in mature fields, where most of the property being sold is proved developed producing, a comparable sale may be a good indicator of FMV. ‘The benefit to this approach is its Garb, pp. 8-9. Garb at p. 10. “THOMPSON & KNIGHT, LP ATTORNEYS & COUNSELORS 1200 Smith Street, Suit 3600 Houston, Texas 77002 “Teles THL6S48111 Fax: 7136844871 Webs wwwaklaw.com 15simplicity. Because time is ignored in this method, a long lived property is favored (yields a higher FMV) even if the production rate is low.* 2) Rule of Thumb Methods. The various rule of thumb methods have merit but do not consider the length of time during which revenue will flow from the investment. Naturally, a dollar today is worth more than a dollar 10 years from today, so that a failure to take time into account will yield an incorrect FMV calculation. Thus, the rules of thumb should not be used except in conjunction with other methods that take time factors into account. * The four most familiar rule of thumb methods are: (1) price paid per barrel equivalent of reserves; (2) price paid per equivalent barrel per day of producing rate; (3) profit to investment ratio; and (4) current income rate for a specific period of time. These methods do not require sophisticated reserve studies and are easy to calculate. However, they do not measure the maximum negative cash position that the purchaser will experience. Also, these tests do not consider market uncertainties, nor time (and thus favor long lived properties). *” The price per equivalent barrel method requires a calculation of the quantity of reserves through a reserve report. The gas reserves (measured in MCF) must be converted to barrels (or vice versa) to achieve comparability. It takes about 6 MCF of methane gas to equal the BTU heating equivalent of a barrel of oil. ‘Thus, one way to achieve equivalency is to take the total gas reserves in MCF and divide by 6 to yield Barrels of Oil Equivalent (BOE). Or, the other way, take the barrels la. 1d, 311g, “Thomson & KNIGHT, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 Houston, Texas 77002 Tele: 713.6543 Fars 7136541871 16of oil, multiply by 6, and add it to the MCF of gas to yield MCF of gas equivalent (MCFE). Then the subject property's reserves can be compared to the comparable property and a price in $/BOE or a price in $/MCFE can be compared.”* In the 20" Annual SPEE Survey, dated June, 2001, 149 respondents were sampled®? and advised that, in those cases where $/BOE were calculated, the average low value within the ranges provided by respondents was $5.5/BOE with a median low value of $4.2/BOE. The average high was $8.7/BOE with a median of $7.0/BOE. In the 19th Annual SPEE Survey, dated June, 2000, 141 respondents were sampled”? and advised that their BOE/MCF conversion factors were as follows: TABLE | Lowest Highest AVE BOE/MCF Size of transaction S/BOE S/BOE SIBOE Conversion <$1 mm $0.10 $26.00 $5.70 10 SI mm to $10 mm $0.61 $7.00 $4.13 66 $10mmto$100mm $0.74 $23.00 $3.87 68 over $100 mm $0.94 $8.74 $3.79 60 Total Weighted Average $4.62 Using the total weighted average, we see that $4.62 was the price paid for an average BOE (barrel of oil equivalent) during the reporting period ending June, 2000, among the 141 respondents. ‘We might concluded, therefore, that 1 million BOE of proved reserves (risked) might have a fair market value of $4.62 million, and certainly somewhere between $3.79 and $5.70 million. Ifthe size of the sale being considered were in the $1 million to $10 million range, the value would be closer to the range of $4.13 to $5.70 million, assuming other variables were constant. “Id. “Note that the SPEE Survey is only a survey and does not purport to be anything more than a survey. Its statistical accuracy is a separate issue and is not addressed. ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 7‘The price per producing equivalent barrel per day method is similar to the price per equivalent barrel method. It also does not account for time but further, it does not account for nonproducing reserves that can often be a significant part of the value of an oil and gas property. This guideline is not recommended for general use. ** The profit/investment ratio method is simply the future net revenue (gross revenue less costs but undiscounted for time) divided by the cost. Investors have historically sought a ratio of between 2.5 and 3. If commodity prices remain stable, this is a good indicator of value. However, this ‘method is unreliable if commodity prices decline dramatically. This method also has the weakness that it does not account for the time value of money. The current income rate multiplied by a specific period of time method is calculated by taking a given number of months of the current monthly net income. The number of months typically ranges between 24 and 60, depending on different variables and uncertainties. This method is not frequently used today other than for a quick estimate. ** @) Income Forecast Methods. The cash flow methods are the most commonly used methods for determining FMV at the present. As stated before, the 2001 SPEE Survey found that 86% of respondents utilized this method. One of the strengths of the cash flow method is that it accounts for time it will take for the reserves to be produced, and thus carefully accounts for the time value of money. The weakness of “Garb at p. 11. "Id. lds THOMPSON & KNIGHT, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 18this method is that it is dependent upon the engineering projections of production and revenue, including quantities of recoverable reserves into the future, rates of recovery, and prices in the future. ‘The SEC requires publicly reporting companies to utilize the cash flow method of reporting the value of proved reserves, using a discount rate of 10% (*PV10") with current prices but without escalation of prices. The PV10 calculation of SEC reported reserves is generally higher than real- world FMV but unescalated prices are often lower. It is worth noting that the SEC also requires a write-down of reserves to the lower of either (a) PV10 with unescalated prices or (b) cost, so that if reporting date occurs during a period of reduced commodity prices, the SEC reported reserves may be written down, even though prices may ultimately recover. Accounting rules do not permit a “write-up” after a write-down has occurred. This occurred in January, 1998 and for the 6 months following, when commodity prices were dramatically lower than in prior periods. A slow recovery began in the fall of 1998 but reserves of publicly reporting companies were not written up. This resulted in a large number of E&P companies being out of compliance with loan and indenture covenants. This, in tum, required recapitalization, sale, or refinancing by a number of large public companies. The discounted future net revenue method (*DFNR") is the most important and single most widely used method of calculating FMV of an oil and gas property. It is unique to the property being valued. However, itis important to note that reserves in different categories must be assigned “Id. at pp. 11-12. THOMPSON & KNIGHT, LLP [ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600, Fax: 7136541871 Web: wwwthlaw.com 19different FNRs, so that different risk factors can be applied. The “risk factors" are intended to reflect the uncertainties attributable to those different categories. (See discussion of risk factors below.) Once the appropriate risk factors have been applied and the total DFNR is known for the aggregate properties, then certain rule of thumb methods are applied to the DFNR number to yield the FMV. These rules of thumb are: (1) internal rate of return (“IRR”); (2) specific fraction of DFNR; (3) payout time; (4) investment efficiency ("IE"); (5) PW at a specific discount rate; (6) specific years of FNR; and (7) percent of price returned in the first year.** Briefly, the DFNR rules of thumb are as follows: (1) The JRRis the rate that discounts the FNR to the same value as the purchase price. It is the rate of interest that the investor will receive if he gets the FNR after paying the purchase price for it, The IRR method is also known as the Return on Investment (“ROI”) method. If PV15 of a property is $1 million (the DNFR), then an investor could pay $1 million and receive an IRR of 15%, The benefit of this method is that the 15% IRR can be compared to any other investment, with zero risk or with risk commensurate with the property being evaluated. (The DNFR has already been risk adjusted to account for uncertainty. ‘The risk factors are a critical assumption in the value calculus.) The 20" SPEE Survey reported that, out of 149 respondents, 4% preferred using the ROL method of determining value of oil and gas properties and was the second most popular (behind discounted cash flow at 86%). Garb opined in 1990 that the IRR method was probably the most Sid. at p. 12. ‘THoMPsoN & KniGaT, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 Houston, Texas 77002 ‘Teles TH36548111 Far: 7136541871 ‘Webs wor.thlaw:com 20popular one used at that time.”* The weakness of this method is that it does not take into account the maximum negative cash flow position of the investor or the payout time of the project. (2) The specified fraction of DENR method is based on PW calculations. The DFNR is calculated using a specified discount rate. The FMV is then calculated using a specific percentage of DENR, usually between 67% and 75%, (3) The payout time method has historically been a widely used method of determining FMV. Typically, investors look for a 3-5 year payout. If payout requires more than 5 years, a property is not desirable. The obvious weakness is that it assumes a constant rate of depletion of reserves, an assumption that may not be and usually is not valid, (4) The investment efficiency or IE method is the DFNR divided by the discounted investment price, both discounted at the same rate. The higher the rat (greater than zero), the better the project. According to Garb, the better oil and gas projects usually generate an IE of 0.7 or better.” Note that this method does not result in a FMV calculation but rather is a measure of desirability of an investment (unless the purchaser establishes an IE hurdle and thus backs into a FMV calculation), (5) The PW ata specified discount rate method uses a high discount rate to adjust for uncertainty and risk. Some investors consider PV20, PV18 and PV1S as a suitable indicator of FMV." Again, this does not determine FMV unless the expert believes that a specific discount rate “Id, at pp. 12-13. Td. at p. 13. “Id. at p. 16. ‘TuoMrson & KNIGHT, LLP ATTORNEYS & COUNSELORS 1200 Smith Stree, Suite 3600 Houston, Texas 77002 “Teles T6544 Fax 7136541871 Web: wwwsthdaw.com 21yields the FMV calculation, or from comparables the expert is able to determine what discount rate is being used in the market. (6) The specified years of FNR method is similar to payout time method. It measures the desirability of a given investment compared to another. However, unless the expert is able to discern from the market what the number of years is, one cannot determine FMV from this alone, (1) The percent of price returned the first year method indicates how quickly the investment will be retumed. This is a measure of desirability of the investment. It does not indicate FMV unless a specified period of time is known to be the rule in the market.” (4) Replacement Cost Method. ‘The replacement cost method for determining FMV comes from the real estate industry." This method has little utility in the oil and gas industry except in the case of undeveloped leasehold interests. (8) Reconciliation and Conclusion. Garb has carefully considered all these methods of calculating FMV and concludes that no single method is always right. Each method has strengths and weaknesses, and each is appropriate for some types of property and not for others. Most valuation engineers use a computer program that allows the expert to “plug in” various criteria and calculate the resulting FMV conclusion using each of these methods and more. Using a combination of all these methods allows the evaluator to observe a number of possible FMV conclusions and then to use the judgment and wisdom of the id. 1 ‘THomPsow & KeiciT, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 Houston, Texas 702 ‘Tele: THL6548111 2evaluator’s experience to derive a single FMV conclusion that is, hopefully, close to being correct within the market.’ It is significant to note that A single yardstick in itself is fallible and should not be considered as an adequate ‘measure of an investment. To ensure against oversight, all the yardsticks should be reviewed, and those that seem out of line should be studied.* However, it is even more important to recognize that The revenue forecast approaches are not more reliable than the engineering assumptions used to estimate the future production and revenue for the property. None of the approaches are more reliable than the estimates of future oil and gas prices on which they are based. E. The Financial Expert's Method of Valuing Oil and Gas Assets. The preceding discussion focused on the reserve engineer's methodology for determining the fair market value of oil and gas reserves in place. Itis often necessary, however, to value a company as a “going concern” rather than determine the liquidation value of the assets. In this case, an investment bank or financial expert is generally necessary in order to opine as to the value of the oil and gas business, though the base data utilized will, of course, be the estimate and classification of reserves in place as determined by a reservoir engineer. When an investment banker or financial expert prepares an expert report on the FMV ofan oil and gas company, he typically calculates value using three methods: (1) discounted cash flow ("DCF") or “income” approach; (2) a transaction approach; and (3) a market approach. (1) The Discounted Cash Flow Approach. sg yy Id. at p. 17, “id. 1200 Smith Street, Suite 3600 Houston, Texas 77002 Web: woewthdaw.comIn the DCF approach, the evaluator must utilize a Reserve Report prepared by a qualified reservoir engineer. Itis worth noting that the value conclusion reached with the DCF approach is no better than the underlying Reserve Report, including the assumptions that go into that determination. (See discussion of reserve reports above.) In this approach, the PDP reserves are valued at 100% of DCF, and other proved reserves are discounted using appropriate risk factors. (See discussion of Risk Factors above.) The risk factors used by the financial expert are generally those taken from the annual SPEE survey, also discussed above under Risk Factors, ‘The FMV evaluator should review the underlying reserve report and its assumptions for reasonableness and should make adjustments where, in the evaluator’s opinion, such are necessary and appropriate. The DCF approach will yield a FMV opinion by utilizing the methods used by reservoir engineers (discussed above), ie., the DFNR rule of thumb approaches, usually internal rate of return (“IRR”) and/or PW ata specific discount rate, Often, the financial evaluator using the DCF method will study the market and determine the applicable PW discount rate being used by buyers currently in the market and, applying that discount rate to the risked DFNR, reach the value conclusion. This ‘method has the strengths and weaknesses discussed by Forrest Garb, above, i, it accounts for the time it will take for the reserves to be produced, and thus carefully accounts for the time value of ‘money, but it is dependent upon the engineering projections of production and revenue, including quantities of recoverable reserves into the future, rates of recovery, and future prices. “Id. at pp. 11-12. ‘Tomrsow & KNIGHT, LLP [ATTORNEYS & COUNSELORS 1200 Smith Steet, Suite 3600 Houston, Texas 7002 ‘Tele: TL6S48111 Fax: 7136541871 Web: www.thdaw.com 24In short, for the expert to opine as to FMV using the DCF approach requires the evaluator to rely upon (1) the reserve report, as adjusted, and all assumptions contained therein; (2) appropriate risk factors; (3) appropriate pricing assumptions; and (4) appropriate discount rates. (2) The Transaction Approach. In the transaction approach, the expert must take the reserve report's conclusion of total recoverable reserves, convert that to either BOE or MCFE, and compare it to other companies in the market place with known reserves of BOE or MCFE. It is possible to consider other sales of properties in the market over a comparable time period by using various services, including Randall & Dewey, and J. Herold, Inc. This edition reports U.S. upstream merger acquisitions and divestment activity based on transactions announced in the first half 2001. The total announced volume was $10.6 billion in 101 transactions. The average acquisition cost for the 54 transactions reporting both consideration and proved reserves was $7.57/BOE compared to $6.38/BOE for 2000 and $7.49/BOE for 1999. For the first half, 22 stock transactions totaling $8.0 billion with an implied reserve value of $7.50/BOE accounted for 75% of the MA&D market while 79 asset transactions accounted for $2.6 billion or 25% of the first half dollar volume for an implied reserve value of $7.86/BOE. * Using Randall & Dewey's report, it is seen that prices for properties are increasing, going from $7.57/BOE in the first half of 2001, compared to $6.38/BOE for 2000, and $7.49/BOE for 1999. Randall & Dewey also make the observation that prices are increasing from the 1990s compared to 2001. Itis interesting to note that the average implied reserve value for stock deals in the ten years of the 1990's averaged $6.30/BOE while the average for asset deals was “Shttp://www.herold.convresearch/disp_home “Randall & Dewey, Transactions Review, hup://www.randew.com/research/QAR/transactions.htm (January 19, 2002). THOMPSON & KNIGHT, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Howson, Texas 7102 ‘Teles THAGS4S1I1 te 3600 ‘Webs wothlaw:com 25‘$4.56/BOE, compared to $7.50/BOE and $7.86/BOE, respectively, in 2001. Based on the five-year forward curve averaging $3.62/MMBBu and $22.97/Bbl at mid-year, itis a good bet that historical valuation metrics will be of questionable value going forward.7 Using known transactions in the market, itis possible to identify comparable transactions, adjust for types and quantities of proved reserves, make appropriate adjustments for location and overall desirability, and reach a value estimate. This approach also relies on the base reserve report and its underlying pricing and related assumptions. However, because the unrisked proved reserves of public companies are known from SEC filings, itis possible to avoid having to apply a “risk” factor to the various categories of proved reserves. This avoids the possible use of an erroneous risk factor, but it also adds a layer of uncertainty in that properties heavily weighted in PUDs will be valued the same as PDP reserves, yielding an obviously incorrect value conclusion. (3) The Market Approach. Finally, there is the market approach, which relies upon the market's value of publicly traded companies having similar types of reserves. Again, this requires converting the comparable companies’ reserves into BOE or MCFE, and comparing those reserves to each other. It is also necessary to be certain that the type and quality of reserves are comparable, thus avoiding a comparable that is more heavily weighted in PUDs than in PDPs. In short, comparables must “truly” be comparable. Once companies with similar reserve profiles are identify, then EBITDA® is 71g, *$ EBITDA is an acronym for “earnings before interest, taxes, depreciation, and amortization.” Its, in essence, a calculation of net operational cash flow before non-operating, items are deducted. ‘THomrso & KvicHT, LLP [ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 26calculated and compared. In theory, the public market values the shares of publicly traded companies on the basis of EBITDA, with the market capitalization (ie., FMV of the company) being a multiple of EBITDA. Note that there is an issue of whether to apply a “control premium,” based on the fact that minority shares are sold in the market place, whereas the interest being valued may be the “controlling” ownership of the company. Purchasers typically pay more for a controlling interest than a buyer would pay a block of minority stock. Thus, it may be appropriate to increase the value conclusion by a factor appropriate to reflect the “control premium.” Again, there are ‘companies that provide studies of the “control premium” in the market, including Houlihan, Lokey, Howard & Zukin,® including such data in the Mergerstat Review.” (4) The Reconciliation of the Three Approaches. ‘The most important and the most difficult part of reaching the value conclusion by the financial expert is reconciling the three methods used. In theory, the three methods ought to be reasonably close to each other, and if they are dramatically different then the expert needs to do further research to understand and explain why. It is certainly true that the dominant factor in valuing oil and gas companies is the DCF or income approach, and thus that approach should be given greater weight than the other two. The amount by which itis weighted is, however, up to the judgment of the evaluator and the exercise of that judgment must be explained in a reasonable fashion by the expert. http://www. hlhz.com/ http://www.mergerstat.com/ THoMrsoy & KNIGHT, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600, Houston, Texas 77002 ‘Teles THL6S48111 Fax: 136844871 aKa. 27Ill. Qualification of Expert Witnesses in Valuation Trials. Itis almost always necessary to have an expert witness testify as to the value of oil and gas, properties. A. The Party with the Burden of Persuasion Must Offer Expert Witness Evidence that Satisfies the Daubert Requirements for Admissibility. The party with the burden of proof, or at least with the burden of persuasion, must offer an expert witness who is a qualified expert on the subject of fair market value and whose opinion is reliable and relevant.“ In order to be qualified as an expert, the witness must be shown to be an expert on the subject of fair market value of oil and gas properties based upon “knowledge, skill, experience, training, or education.” Further, the content of the expert’s testimony must assist the trier of fact to understand the evidence or to determine a fact in issue.” The fact that a witness is a highly qualified reservoir engineer does not necessarily equate to being an expert on fair market value of such properties. Credentials can be significant in determining whether an expert is qualified but they are not necessarily determinative. The key issues are reliability and reliability, and the one who determines those issues is the gatekeeper - the trial judge. “'Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993). Fep. R. Evip. 702. a. “Christophersen v. Allied-Signal Corp., 939 F.2d 1106, 1112-1113 (5" Cir. 1991), cert. denied, 112 S. Ct. 1280 (1992) (“The questions .... do not stop if the expert has an M.D. degree. That alone is not enough to qualify him to give an opinion on every conceivable medical question.”) ° Hucker v. City of Beaumont, 147 F. Supp.2d 565, 569 (E.D. Tex. 2001). “THOMPSON & KNIGHT, LLP ATTORNEYS & COUNSELORS Teles TELAS48111 Fax: 7136841871 Webs wwwailaw.com 28[U]nder the Rules, the trial judge must ensure that any and all scientific testimony or evidence admitted is not only relevant, but reliable, The Supreme Court has ruled that “relevancy” and “reliability” are implicit requirements of Rule 702.” To ensure that expert testimony comports with these requirements, the trial court will conduct a preliminary assessment of whether the reasoning or methodology underlying the opinion can properly be applied to the facts in issue. To make this assessment, the court uses four factors (which are not meant to be exhaustive): (1) whether the theory or technique used can be and has been tested; (2) whether the theory or technique has been subjected to peer review and publication; (3) the technique’s known or potential rate of error; and (4) the general acceptance of the theory or technique by the relevant scientific community. In Daubert v. Merrell Dow Pharmaceuticals, Inc., (“Daubert”), the Supreme Court made clear that the gatekeeper requirements of the trial judge are not limited to novel or untested theories; the requirements apply to established theories as well.”” “Daubert, 509 U.S. at 589. ° As a result of Daubert, Federal Rule of Evidence 702 was amended, effective December 1, 2000, and now reflects the Daubert inquiry. The rule now reads: If scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if (1) the testimony is based on sufficient facts or data, (2) the testimony is the product of reliable principles and methods, and (3) the witness has applied the principles and methods reliably to the facts of the case Fed. R. Evid. 702. ® Daubert, 509 U.S. at 592-93. Pld. at 593-95. Id. at $92. n.11. THOMSON de KNIGHT, LLP ATTORNEYS & COUNSELORS 1200 Smith Stree, Suite 3600 29Courts hold that even though the Daubert factors are nonexclusive, in the vast majority of cases courts should first consider them before addressing whether other factors are relevant to the particular case.”" Although Daubert was a case dealing with the drug Bendectin and human birth defects, itis clear that the requirements are also applicable to opinions of value.” After Kumho clarified the notion that the requirements of Daubert apply to all types of expert testimony, some have argued, albeit incorrectly, that Kumho represents a liberalizing of Daubert, thereby favoring the admission of expert testimony.” ‘Naturally, reliable testimony must be based on an accurate foundation: [Wyhere [expert] testimony's factual basis, data, principles, methods, or their application are called sufficiently into question . . . the trial judge must determine whether the testimony has a ‘reliable basis in the knowledge and experience of the [relevant] discipline.” 7" Underwriters at Lloyd's of London v. McDermott Int'l, Inc., 2002 U.S. Dist. Lexis 278, at *11 (Jan. 17, 2002); see also Black v. Food Lion, Inc., 171 F.3d 308, 311-12 (5" Cir. 1999). See Kumho Tire Co. v. Carmichael, 119 S.Ct. 1167, 1175 (clarifying that Daubert gatekeeping function applies to all expert testimony); Frymire-Brinati v. KPMG Peat Marwick, 2 F.3d 183 (7th Cir. 1993) (a rough calculation of value is not admissible); City of Tuscaloosa v. Harcros Chemicals, Inc., 877 F. Supp. 1504 (N.D. Ala. 1995); Inre Aluminum Phosphide Antitrust Litig., 893 F. Supp. 1497 (D. Kan. 1995). ® See Nelson v. Tennessee Gas Pipeline Co., 2001 U.S. App. Lexis 3526, at **18 (Mar. 9, 2001) (holding party’s argument that Kumho constitutes a liberalization of Daubert to be inaccurate); but of Rushing v. Kansas City Southern Ry. Co., 185 F.3d. 496, 507 (5" Cir. 1999) (“As long as some reasonable indication of qualifications is adduced, the court may admit the evidence without abdicating its gatekeeping function.” “Kumho Tire, 119 S.Ct. at 1175. See also American Tourmaline Fields v. Int1 Paper Co., 1999 WL 242690 (N.D. Tex. 1999) (damages testimony excluded based on Daubert analysis). “Tomson & KNIcwT, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 Houston, Texas 77002 Tele: 16548111 ans 7136841871 Web: worwtidaw.com 30Inthe final analysis, "it is not so simply because an expert says it is so."”* Anexpert cannot base his, opinion on "improbable inferences and unsupported speculation." Likewise, the expert’s opinion is inadmissible if the underlying facts or data are flawed.”” An expert may not render a personal or highly subjective opinion, where in essence, the expert is “choosing up sides."”* In order for the expert's testimony to be considered reliable, he must testify based on an apparent methodology.79 In short, in order for the trial court to allow the witness’ testimony, the court must find that (1) the witness is qualified as an expert on fair market value, (2) the witness’ methodology is both proven and reliable, and (3) the witness’ underlying data is accurate and reliable. It is also required that the proponent of the evidence have tendered to the opponent a signed, written report of the witness containing a statement of the bases of his opinion." (1) The Methodology Used by the Witness to Determine FMV must be Acceptable and Reliable. "General Electric v. Joiner, 118 S. Ct. 512, 519 (1997). "Michaels v. Aritech, Inc., 202 F.3d 746, 755 (SthCir. 2000). "Slaughter v. Southern Tale Co., 919 F.2d 304, 306-07 (5" Cir. 1990) (excluding opinion based on erroneous data). Owen v. Kerr-McGee Corp., 698 F.2d 236, 240 (5" Cir. 1983) (“questions which ‘would merely allow the witness to tell the jury what result to reach are not permitted."); see alsoNelson v. Tennessee Gas Pipeline Co., 2001 U.S. App. Lexis 3526, at **18 (Mar. 9, 2001) (holding expert excluded where opinion formed only for purposes of litigation); see Munoz v. Orr, 200 F.3d 291, 301 (5 Cir. 2000) (holding expert who relies on opposing party's data compilations gives rise to ‘common sense skepticism’ of opinion). ”* Underwriters at Lloyd's of London, 2002 U.S. Dist. Lexis 278, at *11 (noting methodology endows expert with necessary ‘indicia of realiability’). Rule 26(a)(2)(B), Fed. R. Civ. P. “Twomrsow & KnicnT, LLP ATONNEYS & COUNSELORS 1200 Smith Street, Suit 3600 Houston, Texas 77002 “Teles TL6848111 Fav: 713684871 Web: wwwthlaw.com 31It is essential that the expert witness who gives an opinion as to FMV be qualified to and actually determined the price at which these properties would change hands in an open market transaction between a buyer and a seller. Such an expert witness typically should perform an analysis of the prices that buyers and sellers were paying for similar properties. An arbitrary application of discount rates and risk factors without regard to the market place is not calculated to yield an accurate FMV determination, The key is what risk factors and discount rates that buyers and sellers in the market were paying for such properties on the relevant value date. The risk factors utilized by the expert witness must be contained in the witness’ report or work papers, as required by Rule 26, and in any event should be based on objective evidence rather than being entirely subjective. Daubert, Kumho, and Frymire all make clear that an expert testifying on the subject of value ‘must have a valid methodology and an objective basis for the opinion offered. In order to allow the witness’ opinion into evidence, the court must first find that his opinion is based on valid data and a proper methodology, and is a reliable indicator of fair market value. Typically, this requires that the witness use an objectively verifiable methodology for arriving at a market value conclusion."" tis not enough for an expert to pass his hand over the worksheet and declare a particular number to be “fair market value.” Expert witness testimony that is entirely subjective does not satisfy Daubert and must be excluded.” “'In re TMI Litigation Cases Consolidated II, 922 F. Supp. 997, 1028 (M.D. Pa. 1996). Id. (“His [expert's] method of deriving weighted scores for his six factors is entirely subjective, and as such, it cannot be characterized as a scientific means of testing his hypothesis.") ‘Twomrson & KeacitT, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600, Houston, Texas 7702 Tele: 713.6548 Fas: 71365418 Web: worwtidew.com 322) A Reserve Report is Not “Fair Market Value”. Occasionally, a witness will simply prepare a reserve report and declare that PV1S is fair market value. Without more, this should not be admissible. ‘This is simply an opinion as to the ability and risk associated with producing and recovering the oil and gas reserves. Thisis essentially a reserve report and not an opinion of fair market value. @) The Expert Witness Must be Qualified by Experience and Training to Render an Opinion as to Fair Market Value of Oil and Gas Assets. It is the proponent’s burden to demonstrate that the witness is an expert on “fair market value.” A fine reservoir engineer with a great deal of experience in “modelling,” may lack experience in determining the price at which the properties would change hands in an open market transaction. In order for the opinion to be admissible, there must be some evidence that the witness can correlate his “risked discounted cash flows’ to market prices during the relevant time period. The valuation question faced by the trial court is: 1. What reserves would a purchaser perceive may be found on the debtors’ properties, and what oil and gas production would a purchaser expect to achieve over time? 2. What prices and other economic factors would a potential purchaser apply to that production, in order to tum it into cash flow? 3. At what price would such properties change hands between a buyer and seller, each with relevant knowledge, and neither under a compulsion to buy or sell? A reservoir engineer may be an expert on the first (classification of reserves and engineering), but not be an expert on the last two. (4) The Expert's Opinion on FMV Ought to be Internally Consistent. ‘Whatever standards the proffered expert chooses to follow should be followed rigorously so as to produce an opinion that is internally consistent. This is true as to definitions of classes of reserves and use of discount rates and risk factors. An expert who fails to follow his own definitions THOMPSON & KNIGHT, LLP ATTORNEYS & COUNSELORS 1200 Smith Steet, Suite 3600, Houston, Texas 7002 “Tee: T3L6848111 Fax: 7136541871 ‘Webs ww.hlaw.com 33creates an opinion that is unreliable because it is inconsistent with the methodologies stated in his own report. The opinion of an expert who fails to follow his own guidelines is inherently unreliable. (8) The FMV Opinion Must be Based Only on Data that is Available to Buyers and Sellers in the Market Place. ‘The definition of fair market value is that of an open market transaction between a theoretical buyer, and a theoretical seller, both without a compulsion to buy or sell, and both with knowledge of the property. It is impossible for such an opinion to be based upon secret data that is not generally available to the public or the marketplace at large. Thus, an expert seeking to reach a FMV conclusion should not utilize, e.g., proprietary 3-D seismic™ to redraw the geologic maps if that data is not reasonably available to buyers and sellers in the market place. It may be impossible for a theoretical buyer and seller to have access to this type information in an open market transaction, ‘An opinion based upon data not generally available to potential purchasers is flawed and thus impermissibly tainted. B. The Expert Must Tender a Report that Sat 26(a)(2)(B), Fep. R. Civ. P. ies the Requirements of Rule (1) Rule 26(a)(2)(B) Requires a Written Report Containing the Basis for the Expert's Opinion. In re TMI Litigation Cases Consolidated II, 922 F. Supp. 997, 1030 (M.D. Pa. 1996) (’Dr. Motholt’s technique bears little resemblance to his own articulation of established and reliable methods.”) “Proprietary 3-D seismic is geophysical information belonging to third party and not generally available to the public, as opposed to public data that is available for a fee. ‘Thompson & KwicuT, LLP ATTORNEYS & COUNSELORS 1200 Smith Stree, Suite 3600 34Part and parcel of the pretrial process, including the court's gatekeeper role under Daubert,*° (discussed in detail above), is the obligation of the proponent of expert testimony to provide an expert witness report that complies with Rule 26(a\(2)(B), FED. R. Civ. P. That rule provides, in pertinent part: (B) Except as otherwise stipulated . .. this disclosure [of identity of experts] shall, with respect to a witness who is retained or specially employed to provide expert testimony in the case . .. be accompanied by a written report prepared and signed by the witness. The report shall contain a complete statement of all opinions to be expressed and the basis and reasons therefor; the data or other information considered by the witness in forming the opinions; any exhibits to be used as a summary of or support for the opinions; (2) Rule 37(c)(1) Mandates Exclusion of Evidence that does not Comply with Rule 26(a)(2)(B). Rule 37(c)(1), FeD.R. Civ. provides that a party who fails to comply with the disclosure requirements of Rule 26(a) shall not be permitted to use such witness at trial. (1) A party that without substantial justification fails to disclose information required by Rule 26(a) or 26(e)(1) shall not, unless such failure is harmless, be permitted to use as evidence at a trial, ata hearing, or on a motion any witness or information not so disclosed.*” Failure to comply with the requirements of Rule 26(a) requires exclusion under Rule 37(c)(1). [T]he requirements of the Rule 26(a) are mandatory as to an expert retained to testify. If the expert is unable or unwilling to make the disclosures he should be excluded as, a possibility for retention as an expert witness in the case.” *S Daubert, 509 U.S. 579 (1993). *Rule 26(a)(2)(B), FED. R. Civ. P. (emphasis added). Rule 37(¢)(1), FeD.R. Civ. P. “China Resource Products (U.S.A.) Ltd. v. Fayda Int 1, Inc., 856 F. Supp. 856, 866-67 (D. Del. 1994) (mandatory exclusion). ‘THomson & Ksicn, LLP ATTORNEYS & COUNSELORS 1200 Smith Steet, Suite 3600 Houston, Texas 77002 Teles TLAS48111 Fax: 713684871 Webs www.thlew.com 35(3) The Expert Report Must Include an Explanation of the Basis for the Opinion of Value. ‘The basis for an expert's fair market value opinion must be contained in the written report as. required by Rule 26(a)(2)(B). This is also true in bankruptcy court because Rules 26 and 37 apply through BANKR. R. 7026 and 7037, and both apply in contested matters. Rule 26(a)(2)(B) requires that the expert provide a written report, signed by him, containing his opinion and the bases forit. A failure to provide the required report means the witness may not testify.”" IV. Conclusion. “There are no problems -- only opportuni 2” Inno discipline is this aphorism more true than in valuing oil and gas properties. Each case has its own problems and opportunities that reward the astute practitioner for a job well done. “Nguyen v. IBP, Inc., 162 F.R.D. 675, 681 (D. Kan. 1995). See also Sierra Club v. Cedar Point Oil Co., Inc., 73 F.3d 546, 572 ce Cir.), cert. denied, 519 U.S. 811 (1996) (Citing factors to consider and affirming exclusion); Smith v. State Farm Fire & Cas. Co., 164 F.R.D. 49, 54 (S.D. W.Va. 1995) (mandatory exclusion). Bankr. R. 9014. "Rule 37(c)(1). Jn re TMI Litigation Cases Consolidated II, 922 F. Supp. 997, 1003- 04 (M.D. Pa. 1996) (bad faith failure to comply with Rule 26 requires exclusion of expert testimony under Rule 37) “THOMPSON & KNIGHT, LLP [ATTORNEYS & COUNSELORS 1200 Smith Steet, Suite 3600 Houston, Texas 77002 Teles TI6S48111 Fax: 7136541871 Web: wwew.thlaw.com 36V. Bibliography A. Books and Treatises F, Allen, and R. Seba, ECONOMICS OF WORLDWIDE PETROLEUM PRODUCTION (Oil & Gas Consultants, International, Inc.: Tulsa, Oklahoma, 1993). ‘THE APPRAISAL OF REAL ESTATE (Appraisal Institute, 10" ed. 1992). BARKLEY CLARK, THE LAW OF SECURED TRANSACTION UNDER THE UNIFORM COMMERCIAL CODE (rev. ed. 2000). G. Desmond and R. Kelley, BUSINESS VALUATION HANDBOOK (Valuation Press, Inc.: Los Angeles, California 1988), ‘THE DICTIONARY OF REAL ESTATE APPRAISAL (Appraisal Institute, 3rd ed. 1993). J. Eaton, REAL ESTATE VALUATION IN LITIGATION (American Institute of Real Estate Appraisers: Chicago, Illinois, 1982), R. Hughes, O1L PROPERTY VALUATION (New York: 1978). The Petroleum Society of the Canadian Institute of Mining, Metallury and Petroleum, DETERMINATION OF OIL AND GAS RESERVES, Petroleum Society Monograph No. 1 (1994). Peter R. Rose, RISK ANALYSIS AND MANAGEMENT OF PETROLEUM EXPLORATION VENTURES (AAPG. ‘Methods in Exploration Series, No. 12, American Association of Petroleum Geologists: Tulsa 2001). B. Published Articles Forrest A. Garb, “Which Fair-Market-Value Method Should You Use?” January, 1990 JOURNAL OF PETROLEUM TECHNOLOGY, p. 8 (1990) Forrest A. Garb & Gerry L. Smith, “Estimation of Oil and Gas Reserves,” Chapter 40, p.40-1, found in HOWARD B. BRADLEY (ed.), PETROLEUM ENGINEERING HANDBOOK (Society of Petroleum Engineers: 1987). ‘Mark Haedicke, “Contracts for the New Natural Gas Business,” 13 ENERGY L.J. 3131 (1992). Alvin C. Harrell & Owen L. Anderson, “Report of the ABA UCC Committee Task Force on Oil and Gas Finance,” 25 Tex. TECH L. REV. 805 (1994), Alvin C. Harrell & JosephR. Dancy, “Oil and Gas Financing Under Uniform Commercial Code Article 9, 41 OKLA. L, REV. 53 (1988). C. Papers and Presentations ‘TuoMeson & KNIGHT, LLP 1200 Smith Stree, Suite 3600 Fae: 7136541871 Web: wwwstilaw.com 37Terry Cross, “Article 2 Issues in Oil and Gas Marketing Transactions,” South Texas College of Law's Advanced Oil and Gas Law Institute, August, 1994. Ryan, “Effect of the Uniform Commercial Code on Oil and Gas Transactions," 18™ ANN. INST.ON OIL & Gas L. & TAX'N 365, 416-22 (1965). Theodore Smith, “How the Uniform Commercial Code Applies to Natural Resources Transaction,” 33 ROCKY MIN, MIN. L. INST. 5-1 (1988). Paul Strohl, “Square Widgets into Round Holes: An Energy Lawyer Surveys the Uniform Commercial Code’s Impact on Energy Business Transaction,” State Bar of Texas, Advanced Oil, Gas & Mineral Law Course, October 6-7, 1994. Douglas J. Whaley, “New Article Nine,” The University of Texas School of Law 19” Annual Bankruptey Conference, Austin, Texas. THoMrsox & Kx, LLP [ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600, Hlouston, Texas 7002 ‘Tele: 6848111 Fax: 7236841871 ‘Webs worw.tlaw:com 38RHETT G. CAMPBELL, attorney-at-law ‘Thompson & Knight, LLP 1200 Smith, Suite 3600 Houston, Texas 77002 did. 713.653.8660 Practice: Business bankruptcy, business and oil & gas litigation and creditors rights. Experienced in all aspects of bankruptcy reorganization and litigation, including preference, avoidance, fraudulent transfer, and trustee claims against officers and directors. Certifications: Mr. Campbell is board certified by the Texas Board of Legal Specialization in civil trial (since 1982) and in business bankruptcy (since 1989). Licenses and admittances: Supreme Court of Texas; Supreme Court of the United States; United States Courts of Appeal for the Fifth, Seventh, Eleventh and Federal Circuits; United States District Courts for the Northem, Eastern, Western and Southern Districts of Texas. Member of College of State Bar of Texas since 1991. Member of the Advisory Committee on Complex Chapter 1 Matters for the United States Bankruptey Court for the Southern District of Texas (1999 - 2001). Born: April 15, 1948, in Wichita Falls, Texas. Education: _B.A., Southern Methodist University in Economics (with departmental honors, The Outstanding Economics Graduate, 1970) and Political Science, magna cum laude and Phi Beta Kappa, in 1970. J.D., SMU cum laude in 1973. Hatton Sumners Scholar, Order of Coif, Order of Barristers. Winner, Russell Baker Moot Court Competition, 1971. Military: Served in the United States Air Force from 1973 to 1977 as a member of the Judge Advocate General Corps, including one year in Southeast Asia and a tour teaching law at the United States Air Force Academy. Professional: In 1977, Mr. Campbell joined Kenneth Morris to form the firm of Mortis & Campbell, P.C., where he practiced until November 30, 2001. Effective December 1, 2001, Mr. Campbell became a senior partner at Thompson & Knight and continues to practice in its Houston office, Personal: Rhett is married to Susan V. Seybold, a Houston native and a pediatric dentist. They have three children and are members of St. John the Divine Episcopal Church. They are members of the Houston Civil War Round Table. Rhett is the chairman of the board of directors of and is active in the Terry Foundation, a private foundation that gives scholarships to high school seniors to attend the University of Texas and Texas A & M University. ‘THowrson & Knicar, LLP ATTORNEYS & COUNSELORS 1200 Smith Street, Suite 3600 Houston, Texas 7002 “Tele: THS6S48111 Fas: 713.654.1871 ‘Webs worm. thlaw.com 39