Case Study: Oil and Gas Transaction, and Valuation Arbitrage
Max-Bid Value provided risk management bidding parameters used to participate and win an asset at auction, without overpaying, and the CFM provided clarity as to refinance options given the true, and much greater availability of equity value in the asset itself.
Preamble: Commercial real estate valuations contrast value between the income approach — which is a calculus of rent receipts and operating profitability — and the comparable market value of an asset which is based on the appraised value of similar nearby properties. Lenders then assess the delta between the two and come up with a financing proposal based on the investor’s need and current economic market condition. The delta itself may present an arbitrage opportunity which investors seek to quickly exploit as they usually don’t last long. My experience is that Valuation Arbitrage in oil and gas presents itself more frequently, and below is a summary of an actual transaction, supported by documentation, to show how we exploited such an opportunity. Bound by confidentiality, I’ve redacted any identifying information as to asset location, API numbers, Lease name, and Lender or Financier details but the CFM schedules, Bank Term Sheets, and excerpts from the Executive Summary are from a real transaction, and a real valuation arbitrage, in a real oil and gas asset acquisition.
Bidding for Assets using the “Max-Bid Value” Valuation Algorithm: After registering and being approved as a qualified auction bidder, we won the bid at $1.8M, well below the $2.2M Max-Bid Value generated by our proprietary algorithm for the subject asset (see our Blog: Prioritizing Oil and Gas Due Diligence and Determining Max-Bid Value). Since our winning bid did not meet the seller’s confidential Reserve Amount, we agreed to an Auctioneer mediated Direct Negotiate Sale for the same at $2.1M even though the Seller was asking $2.8M. Another bonus was that our due diligence showed remaining proved Oil and Gas Reserves for the asset at 3.7M bbls (link), which projected an asset-based borrowing limit of $5.7M as objectively calculated by our proprietary Cash Flow Model (see our Blog: Due Diligence and Modeling Oil and Gas Acquisitions). We then tested the debt service limit the asset could support by conducting numerous what-if analysis in the CFM, and given our existing banking relationships with known oil and gas banks and hedge fund financiers, we used previously negotiated terms from each as placeholder values in the Assumptions Page until final terms were agreed to. The full CFM schedules for the subject asset are linked including: the Assumptions Page (link); Balance Sheet and Statement of Cash Flows (link); Income Statement (link); and the Funding Schedule (link).
Refinancing Acquired Assets using Reserve Value Valuation: For bankers and financiers it’s all about answering three questions: how much is being borrowed, what is the security or collateral, and when is it repaid or the investor realization. The CFM clearly shows answers to all three questions, but also offers bankers exact monthly principal, interest, and fee payment schedules, while allowing for a myriad of what-if analysis that provides lenders and investors confidence in considering various funding structures and plans. Moreover, since the asset is already owned by the refinance applicant, the purchase price is no longer a borrowing ceiling that artificially limits what can be leveraged, rather the focus of the refinance discussion is on the asset itself and the appraised value of the tangible asset pledged as security, or the proved Oil and Gas Reserves. The variable then, is if the production income of the asset adequately supports the projected debt service. All of that is also run through the CFM in real time with the banker and financier. Like any negotiation, capital too, is a commodity valued by how much a borrower is willing to pay for the capital, so shopping credit facilities is smart business. Credit facilities can be packaged as part of a greater pool of capital for multiple deals in the same space (link), or designated to a specific asset or transaction (link). We sought proposals for various refinancing alternatives and received Discussion Term Sheets from several oil and gas banks, and one Hedge Fund (link). Terms were mostly similar and allowed for leveraging the asset pursuant to a bank formula relative to existing PDP, PDNP, and PUD production value (see our Blog: Buying PDP and Cash Flow Certainty), along with the proven and verified Oil and Gas Reserves, and certainty that the asset can consistently make requisite debt service payments.
Valuation Arbitrage: To summarize, Max-Bid Value provided risk management bidding parameters used to participate and win an asset at auction, without overpaying, and the CFM provided clarity as to refinance options given the true, and much greater availability of equity value in the asset itself.
