APPRAISING OIL & GAS EQUIPMENT

Jim HardenMoss Adams LLP

Topics & Agenda

• Why are Oil & Gas Equipment Valuations Required?

• Types of Oil & Gas Equipment to Value

• Machinery and Equipment Levels of Value

• Appraisal Methodologies and Indices

• Oil & Gas Industry & Equipment Trends

Why are Oil & Gas Equipment Valuations Required?• Asset Acquisitions & Divestures• Purchase Price Allocations – for Book & Tax Purposes• Impairment Testing• Property Taxes• Gift & Estate Tax• Federal, State, & International Tax Matters• Litigation & Dispute Matters• Valuations for Collateral Based Lending Needs• Insurance Valuations• Interest Allocations

Oil & Gas Equipment Types to Value

Pipelines Terminals Production Equipment

Onshore Drilling Rigs Offshore Drilling Rigs Other Supporting Equipment

*Sourced pictures from GoogleImages

Machinery & Equipment Levels of ValueReproduction Cost New

Replacement Cost New

Insurable Value

Fair Value in Use

Fair Value

Orderly Liquidation Value

Forced Liquidation Value

Salvage Value

Scrap Value

May be equal in some circumstances

Floor values

Differences in value based on marketing time

Can be “installed” or “removed”

Defined in insurance policy

* Definition and premise of value dictated by highest and best use

Appraisal Methodologies

1) Cost Approach• Direct Method – Depreciated Replacement Cost • Indirect Method – Depreciated [Indexed/Trended] Historical Cost

2) Market Approach• Sales Comparison Approach

3) Income Approach• Discounted Cash Flow Method• Direct Capitalization Method

• The cost approach is the most commonly used method, with market approach used as additional support and validation. The income approach is rarely used for equipment valuations.

Cost Approach

• Specialized assets• Most commonly applied method for valuing oil & gas equipment• Assets with significant capital build cost (i.e. offshore rigs, production or processing equipment,

pipelines, terminals, etc.) • Assets with a limited secondary market or identifiable income stream• Must consider functional and economic obsolescence. Examples:

• Excess capacity in pipelines• Pipeline built to handle 500 million cubic feet per day of gas (mmcfpd), but due to production decline now handling 100 mmcfpd

• Generational changes in onshore or offshore drilling rigs• Depth or horsepower ratings, directional capabilities, etc.

• Under-capacity issues in oil and gas field infrastructure• Increasing H2O volumes in older oilfields and lack of equipment size to handle these volumes

• Excess operating costs associated with older gas processing facilities• Older refrigeration plants less efficient than new cryogenic plants

Cost Approach – Methodologies

Original Cost Inflationary Trend Factor

Reproduction Cost New Excess Capital Replacement

Cost NewPhysical

DepreciationFunctional

ObsolescenceEconomic

Obsolescence

Indirect Cost Method

Direct Cost Method

Replacement Cost New Physical Depreciation Functional Obsolescence Economic Obsolescence

Vendor QuotesPricing Guides

Manufacturer Quotes

Age/Life Analysis Excess Operating CostsDesign Efficiencies

Replacement > Reproduction = No Excess CapitalNo excess capital → expect increased capex in forecast

Declining Sales PricesIncreased Production Costs

Declining Volumes

Cost Approach – Depreciation & Obsolescence

• Physical depreciation: the loss in value or usefulness of a property due to the using up or expiration of its useful life caused by wear and tear, deterioration, exposure to various elements, physical stresses, and similar factors.

• Includes: curable deterioration, incurable wear and tear, material fatigue, and excess exposure• Indicators: historical and future capital expenditures, production records, discussions with company personnel

• Functional obsolescence (FO): the loss in value or usefulness of a property caused by inefficiencies or inadequacies of the property itself, when compared to a more efficient or less costly replacement property.

• Includes: excess capital costs and excess operating costs• Indicators: not operating at original design capacity, reproduction cost (trended) is not supported by market

replacement cost data due to improvements in technology, materials, manufacturing processes, etc.

• Economic obsolescence (EO): the loss in value or usefulness of a property, such as increased cost of raw materials, labor, or utilities (without an offsetting increase in product price), or similar factors.

• Includes: insufficient business earnings to support adequate return on assets, increased material costs, reduced demand for the product, increased competition, environmental or other regulations

• Indicators: inutility and lack of economic support (short-life vs. long-life).

Cost Approach – Depreciation ExampleIowa Survivor Cure Example (% Good at “x” Age), SL = 10-years, Hold Factor = 10%

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% G

ood

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Determining Economic Life of Oilfield Equipment – Short Life

Determining Economic Life of Oilfield Equipment – Long Life

Cost Approach – Trend Factors

• Trend factors are sourced from industry specific price indexes such as:

• IHS Markit, Energy Equipment• Marshall & Swift, Petroleum

Equipment• Bureau of Labor Statistics, Petroleum

Refinery Equipment• Industry trend factors illustrate historical

equipment pricing for the respective industry.

• Once a trend factor is selected, it is applied based on the asset’s age to arrive at the estimated reproduction cost new.

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Trend Factors

IHS Trending Indices MS Trending Indices BLS Trending Indices

Cost Approach Example – FERC Regulated Crude TerminalIndirect Cost Method

FERC Code Asset Class Acquisition

CostWeighted

Average AgeRemaining Useful Life

Net Useful Life Trend Factor Reproduction

Cost New Excess Capital Replacement Cost New

Physical Dep. Floor

R2 Iowa Survivor Curve

% Good Factor

Replacement Cost New Less

Depreciation

Functional Obsolescence

Factor

Economic Obsolescence

FactorFair Value

160 Other Station Equipment 300,000 5 years 15 years 20 years 0.78 235,345 264,655 500,000 10% 77% 23% $115,000 1.00 1.00 $115,000

161 Tanks Crude Trunk 140,000 22 years 8 years 30 years 1.02 142,800 - 142,800 10% 35% 65% $92,820 1.00 1.00 $92,820

162 Delivery Facilities 550,000 4 years 16 years 20 years 0.97 532,447 117,553 650,000 20% 77% 23% $149,500 1.00 1.00 $149,500

164Office Furniture/Equipment 50,000 1 years 14 years 15 years 1.00 50,000 - 50,000 12% 69% 31%

$15,5001.00 1.00

$15,500

161 Product Tanks 1,227,000 10 years 30 years 40 years 1.14 1,398,780 3,255,537 $4,654,317 20% 60% 40% $1,861,727 0.90 1.00 $1,675,554

Replacement Cost New AnalysisTank Name Tank Type Acquisition

Cost Year Built API 653 Compliant YOS Tank Width (ft) Tank Height (ft) Shell (bbls) $/Bbl Replacement Cost

NewTank 1 Open Floating Roof $120,000 1998 Y-2018 20 44 36 9,749 $38.40 $374,353Tank 2 Open Floating Roof $95,000 1998 Y-2018 20 50 40 13,988 $38.40 $537,123Tank 3 Open Floating Roof $115,000 2003 Y-2015 15 44 40 10,832 $38.40 $415,948Tank 4 Internal Floating Roof $120,000 2003 Y-2016 15 44 36 9,749 $38.40 $374,353Tank 5* Internal Floating Roof $132,000 1993 Y-2018 25 50 48 16,785 $38.40 $644,547Tank 6 Internal Floating Roof $95,000 1993 Y-2018 25 44 36 9,749 $38.40 $374,353Tank 7 Internal Floating Roof $115,000 1993 Y-2018 25 50 36 12,589 $38.40 $483,410Tank 8 Internal Floating Roof $120,000 1998 Y-2018 20 50 36 12,589 $38.40 $483,410Tank 9 Internal Floating Roof $115,000 1998 Y-2018 20 50 36 12,589 $38.40 $483,410Tank 10 Internal Floating Roof $200,000 2003 Y-2018 20 50 36 12,589 $38.40 $483,410Total Tank $1,227,000 121,206 $38.40 $4,654,317* Tank failed 653 inspection and will require cost to cure

Appraisal Methodologies – Market Approach• Relied on to value assets with readily available secondary markets• Depreciation and obsolescence is implied in the market approach• Sources of market data

• Internet• Client experience• Secondary (used equipment) market sales and brokers• Blue Book• Green Guide• Auctioneers (Kruse Energy, Ritchie Bros, Dovebid, Ironplanet, etc.)• Others

Market Approach – Sales Comparison • Comparison of public or private transactions of similar assets

o Ex 1) Research pure-play terminal transactions and calculate multiples of transaction value per barrel of capacity acquired ($/barrel)

o Ex 2) Utilize auctioneer websites to find transacted prices for comparable assets of similar make, model, and age

• If recent, use comparable transactions made by subject company (“back solve method”)o Ex) $17.5M transaction price for 500,000 bbl. terminal = $35/bbl

• Benefits:• Easy to understand and apply

• Limitations:• Pre-revenue companies lack a basis to apply meaningful multiples• Often over-values smaller asset deals unless multiples are adjusted• Lack of comparability across peers due to differences in:

• Margin / Cost structure, Location, Competitive landscape

Market Approach Example – Sales Comparison – Crude Terminals

Terminal Transactions Summary$/Barrel of Capacity

Range Refined Products Crude oil Crude oil + Refined Products All Terminals

Min $0.1 $1.7 $7.7 $0.1Median $38.4 $62.1 $50.9 $50.9

Avg $48.0 $75.6 $65.4 $57.5Max $160.2 $178.6 $180.0 $180.0

Count 21 7 9 37

• ~40 pure-play terminal transactions between 2012 and 2019

• Capacity vs total transaction value.

• Classified deals into the following asset type: Refined Products Crude Oil Crude Oil + Refined Products

• Transactions imply a median multiple range of $38.4 to $62.1 per barrel of capacity for all oil and refined product terminals.

Market Approach – Upstream Oil & Gas – COPAS• The Council of Petroleum Accountant Societies, Inc. (COPAS) provides expertise for the Oil &

Gas Industry through the development of Model Form Accounting procedures, publications andeducation.

• COPAS conducts a bi-annual survey for equipment pricing and compiles the information in acomputerized database.

• COPAS database is generally used as a baseline for new oil & gas equipment pricing.

Market Approach – Upstream Oil & Gas – COPAS Factors• COPAS grades equipment by condition factors A, B, C, D, and E.• The condition factors equate to a percentage of the current new price of an unused piece of

equivalent material. The factors are then multiplied by the current price of new material toestimate an acquisition cost for a used item.

A• Material is unused (and is not in need of repair or

reconditioning)

B• Material has been used and is useable without repair or

reconditioning

C• Material is used and will need repair or reconditioning

before it is reusable

D• Material is no longer useable for its original function but

useable for alternate applications or is obsolete

E • Material is junk, i.e., having scrap value only.

Condition Codes Condition Factors

Determining Economic Obsolescence – Income Approach• Most applicable for pipelines, terminals, or other leasable/rentable equipment

• Discounted Cash Flow Method: based on projected income through remaining life of the asset, to include the asset’s residual value and discounted.

• Direct Capitalization Method: based on first year’s income and build-up capitalization rate.

Income Approach – Discounted Cash Flow

• Present value of forecasted future cash flows using discount rate that reflects risk-return expectations of the investment

• More applicable to assets generating revenue

• Benefits:• Captures the asset-specific growth trajectory and risk-reward profile• Sidesteps the lack of comparability across peer groups

Limitations:• Input parameters can be tough to estimate (revenue, expense, discount rate, etc.)• May yield negative values for early stage projects

Income Approach Example – Discount Rate – Midstream Energy

Income Approach Example – Discounted Cash Flow – Crude Terminal

Offshore Drilling Example – Utilization Matters in Developing Cash Flow Forecast

Market Fundamentals – The Key to Valuation

• Understand Cycles, Trends, Movements and Developments• Oil & Gas, Fuels, Mining, Agriculture, Steel & other Commodities• Cycles can be observed looking at indexes, prices and other raw data• Megacycles should be noted and understood where subject assets fitMid-cycleApogeeNadir

• Care should be taken when valuing assets approaching cycle nadir

What is a Commodity Supercycle?• Long-term trends in the price of commodities.• Different from immediate supply disruptions.• The cycle tends to coincide with extended periods of industrialization or modernization.• Four distinct commodity super cycles since 1899:

1) 1899-1932: Industrialization of the United States in the late 19th century2) 1933-1961: Onset of global rearmament before Second World Ware in 1930s3) 1962-1995: Reindustrialization of Europe & Japan in the 1950s &1960s4) 1996 - Present: Began mid to late 1990s with rapid industrialization of China

*Sourced from visualcapitalist.com

Commodity Price Index (“BCPI”)

*Sourced from visualcapitalist.com

Industry Trends – Oil & Gas Pricing

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Historical & Futures Pricing WTI and HH

Crude Oil - WTI (ICE) Historical Pricing Crude Oil - WTI (ICE) Future Contracts

Natural Gas - Henry Hub (NYMEX) Historical Pricing Natural Gas - Henry Hub (NYMEX) Future Contracts

Industry Trends – Steel Pricing

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Historical & Futures PricingSteel - Rebar

Steel - Rebar (SHFE) Historical Pricing Steel - Rebar (SHFE) Future Contracts

Industry Trends – WTI Pricing vs. USD:EUR Exchange Rates

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Industry Trends – WTI Pricing vs. USD:EUR Exchange Rates

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R2 = 90+%

US Oil & Gas Production: Historical & Forecast

• Record crude oil production of 10.74 mmbbls/d in 2018 eclipsing the previous record of 9.64 mmbbls/d set in 1970

• 2011-2018 CAGR of 9.6%

• US oil production projected to peak at 14.53 mmbbls/d in 2031 2018-2031 CAGR 2.4%

• Annual decline rate of 1.1% to 11.86 mmbbls/d in 2050

• Record dry natural gas production of 29.5 Tcf in 2018

• 2011-2018 CAGR of 3.9%

• US dry natural gas production expected to continuously rise throughout the latest forecast to 43.4 Tcf in 2050, 2018-2050 CAGR 1.2%

Oil & Gas Equipment Trends

• Advancements in technology are impacting demand (downward pricing) for older equipment.

• Horizontal drilling which involves drilling vertically until a shale formation is reached, then a directional drill is used to create a 90-degree curve into the shale.

• Increased demand in horizontal drilling has diminished demand for vertical drilling equipment, such as smaller, low-horsepower drilling rigs.

• Conversely, ultra-deepwater drillships have decreased demand for less capable offshore rigs.

• Pipeline Improvements – significant advances for pipelines have occurred in the physical attributes of construction materials (i.e. mortar-lined and taped-wrapped steep pipe, pre-tensioned concrete cylinder pipe, high-density polyethylene pipe, ductile iron pipe, carbon steep pipe, corrosion-resistance, etc.). These improvements meet stress and fracture resistance standards and are easier to install, maintain and operate, as well as inhibit corrosion.

Summary

• Appraisal Methodologies• The Cost Approach is the most commonly used method, with Market Approach used as

additional support and validation. Income Approach, when applicable, is used to measure economic obsolescence.

• Sources of data: IHS, COPAS, Marshal & Swift, BLS, Equipment Brokers, and various other databases.

• Understand Short and Long-term Commodity Trends• Oil and Gas equipment values are largely dependent on the underlying commodity prices of oil

and gas, prices of materials, as well as advancements in new technology.

Questions?

Lord, please let there be one more oil boom. I promise not to piss it all away this time.

Bumper sticker seen in Houston in 1986