Formula 1 in Las Vegas: The Race That Hopes You Don’t Sleep

Formula 1 in Las Vegas: The Race That Hopes You Don’t Sleep

Brent Shockley, Director at ValueScope

November 17, 2023 

Formula 1 In Las VegasFormula One/1 racing returns to Las Vegas this weekend for the first time in over 40 years.  The Heineken Silver Las Vegas Grand Prix 2023 is the start of a three-year contract with the city; although Formula 1 intends to support the race for at least 10 years and the entertainment and gaming hub of the U.S. intends on a “lifetime partnership” with the top class of international racing.  The nearly four mile track will wind through Las Vegas landmarks, hotels, and casinos with a straightaway section down the famous “Strip” at speeds reaching 212 miles per hour in cars that can range in cost from $12 to $20 million.  The Las Vegas Grand Prix is the next to last F1 race on the 2023 circuit.

The race promises to be a visual spectacle….for those in the U.S. that stay up to watch the event.  The Las Vegas Grand Prix will start at 10pm Pacific time on Saturday night, which is midnight or 1am for half of the U.S.  Typical F1 races are designed for 90 minutes but can often go up to two hours with delays.  To prep the drivers, practice runs are set for late Thursday and Friday evening with qualifying from 12am to 1am local Vegas time on Saturday ‘morning.’

The two F1 races in the U.S. this year (Miami and Austin) started in the mid-afternoon local time but this race was set later for the nighttime atmosphere of Las Vegas Strip and to appeal to international viewership, which greatly exceeds that of the U.S.  Global viewership for F1 races averaged 70 million in 2022.  By comparison, U.S. viewership averaged just over 1 million.  F1 interest in the U.S. has seen a significant increase since the debut of the Netflix series “Drive to Survive” in 2019.  Average U.S. viewership of F1 races jumped about 545,000 in 2017 and 2018 to 672,000 to 949,000 in 2021 and 1.2 million in 2022.

Formula One Group, founded in 1950, was purchased for $4.4 billion in 2016 by Liberty Media.  It operates as subsidiary of Liberty under the Nasdaq ticker FWON.K.  The subsidiary reports $2.8 billion of annual revenue and $560 million of EBITDA.  It’s current market capitalization is approximately $15 billion.  It is reported Liberty Media spent between $400 million to $500 million to stage the race, which included $240 million for a purchase of 39 acres on the northeast corner of Harmon Avenue and Koval Lane for the construction of part of the track and a three-story, 300,000 square foot paddock building constructed in less than a year.   The building is a permanent structure as the hub for future F1 races.

Despite the marketing hype beyond any Vegas headliner show or prior sporting event, preparations and demand for the race have hit a speed bump.  Locals, tourists, hotels, and businesses along the Las Vegas Strip have been frustrated throughout 2023 by construction to turn one of the World’s most famous streets into a racing circuit.  Hotels and casinos initially sold high priced ‘experiences’ in the thousands of dollars to include parties with A list entertainers, celebrity chefs and club type accommodations to view the race.  Joe Pompliano reports hundreds of private jets are set to descend upon Las Vegas paying overnight parking fees of $1,500 to $7,500 per night.   However, as the green light gets closer, general ticket sales have been disappointing, with prices dropping by 60% and hotels slashing room rates by up to 80%.

The city of Las Vegas continues to add major sporting events to its list of entertainment options and attractions.  The $2 billion Allegiant Stadium opened in 2020 as the home of the NFL’s Raiders franchise and will host Super Bowl LVIII in February 2024.  The Vegas Golden Knights, founded in 2017, are the defending National Hockey League champs.  The Las Vegas Aces are back to back WNBA champions and the city is host to part of the NBA’s Summer League. On Thursday, Major League Baseball owners approved the relocation of the A’s franchise from Oakland to Las Vegas.  A new baseball stadium along the Las Vegas strip is expected to be ready for the 2028 baseball season.  The city had no major sports franchises prior to 2017.

*The ValueSport blog is a look at the hybrid world of sports and business.  It is published by the professionals at ValueScope, a leading business valuation and advisory firm headquartered in the Dallas-Ft. Worth area.

Transcending Value – Liquidation, Monetary, Financial, and Strategic Value

Blog 2 of 4: 

This is the second in a series of blogs that attempts to explain and distinguish between various valuation concepts, such as price, fair market value, fair value, liquidation value, intrinsic value, financial value versus strategic value, monetary versus economic value, emotional and psychic value, among others. Environmental, social, and governance (ESG) value is relatively new, and gaining acceptance in corporate America.  Hedonic value has various meanings and uses but is usually thought of as the immediate, emotional gratification (perhaps a cause for impulse buying), as contrasted to utilitarian value.

Many people have heard of the cost, market, and income approaches to valuation, and these various approaches and hybrids can sometimes be applied to determining the different value standards mentioned above.  But while valuation (the process of putting a value on something) is part science and part art, there are well accepted techniques, methodologies, and theories that should be adhered to. Valuation necessarily requires an understanding and deep insight into accounting, economics, and finance.  Now, statistical analysis, behavioral finance, and cultural economics are playing a more frequent role in valuation.

Liquidation, Monetary, Financial, and Strategic Value

The liquation value is simply the FMV without the intangible assets of the business unless certain intangibles such as patents can be separately sold/licensed and utilized by another firm.  The monetary value is just what it says, pure cash value without regard to any psychic benefits.

To the typical private equity group (“PEG”), financial value rules – buy low and sell high.  It is all about cash-on-cash return.  A PEG usually requires higher returns (in part, to compensate for additional perceived risk since a seller will always know more than a buyer); therefore, the financial value is less than the expected monetary value (until they are a seller, of course).  PEG buyers also often look for market inefficiencies to achieve superior returns.  More often private equity buyers compete with strategic buyers (most often corporate buyers) in that revenue and cost savings synergies accelerate their value creation.

Transcending Value - Liquidation, Monetary, Financial, And Strategic Value

For the complete white paper go to: https://lnkd.in/gtPdGNf

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

If you liked this blog you may enjoy reading some of our other blogs here.

Transcending Value – Intrinsic and Fair Value

Transcending Value – Intrinsic and Fair Value

Blog 1 of 4: 

This is the first in a series of blogs that attempts to explain and distinguish between various valuation concepts, such as price, fair market value, fair value, liquidation value, intrinsic value, financial value versus strategic value, monetary versus economic value, emotional and psychic value, among others. Environmental, social, and governance (ESG) value is relatively new, and gaining acceptance in corporate America.  Hedonic value has various meanings and uses but is usually thought of as the immediate, emotional gratification (perhaps a cause for impulse buying), as contrasted to utilitarian value.

Many people have heard of the cost, market, and income approaches to valuation, and these various approaches and hybrids can sometimes be applied to determining the different value standards mentioned above.  But while valuation (the process of putting a value on something) is part science and part art, there are well accepted techniques, methodologies, and theories that should be adhered to. Valuation necessarily requires an understanding and deep insight into accounting, economics, and finance.  Now, statistical analysis, behavioral finance, and cultural economics are playing a more frequent role in valuation.

Transcending Value – Intrinsic and Fair Value

Intrinsic value can be related to psychic or emotional value but normally is thought of as the cash equivalent value (on a present value basis) to a specific owner.  That owner is usually the current owner and the value usually represents the value of the future cash flow, including the proceeds from a future sale.  Since taxes can be quite different in a sale (capital gains) versus income, normally an after-tax analysis is required to understand the scenario that may be more advantageous; hold versus sell.  But, once again, the owner may derive “satisfaction” and other rewards from being the owner/boss.  The tradeoff may be more than money, especially since the owner is incurring more risk.

I have placed the intrinsic value bubble above and to the right of FMV since the owner may have more time value (can realize income for more years and sell at a later date), all the while deriving more emotional or psychic benefits.

Fair value, like intrinsic value can certainly overlay (in the range of possible values) FMV and is normally calculated without regard to discounts associated with the lack of control and marketability.  The fair value of public stock is normally the same as its FMV.  In the case of closely held companies, the two can be markedly different because minority shareholders in private companies usually cannot sell their stock easily or control operations.

Transcending Value - Intrinsic And Fair Value

For the complete white paper go to: https://lnkd.in/gtPdGNf

For more information, contact:

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

If you liked this blog you may enjoy reading some of our other blogs here.

Transcending Fair Market Value

Click to Download:  Transcending Fair Market Value

Transcending Fair Market Value

“Beauty is in the eyes of the beholder.”

Margaret Wolfe Hungerford (née Hamilton), who authored many books, often under the pseudonym of ‘The Duchess’.

When I think about value, I (like most in my profession) think first about fair market value (“FMV”).  The classic definition of fair market value is:

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.[1]

But the concept of value is complex.  It transcends FMV.

At its core, value is the measure of worth for a good or service expressed in monetary terms.  However, since the worth of a good or service varies from individual to individual and under different settings, there are many distinct types of value with distinct definitions (e.g., intrinsic value, fair value, fair market value).

Further, a common misconception is to think of value only in terms of the monetary benefits derived from the good or service, but it is really much more.  The value of a good or service also depends on all of the qualitative and intangible benefits that may not directly lead to a monetary benefit or may even have no monetary benefit at all.

If I buy a rare sports car for, say, $100,000, and I get to view it every time I walk into the garage, what is its value?  Arguably, its value to each buyer is $100,000 or more, or they would not buy it.  Its price is $100,000, and its FMV is $100,000 (assuming it was bought at arms-length in an active market), but I may have agreed to pay much more.  And what is the value of the pleasure I derive from the car, the drive, the fun, and its aesthetic beauty?  The psychological gratification to show it to and discuss it with friends?  How do you measure that?

Similarly, what about a painting on the wall?  It may go up or down in value, but you get to look at it every day.  Not too many people frame stock certificates, or bank statements.

This paper attempts to explain and distinguish between various valuation concepts, such as price, fair market value, fair value, liquidation value, intrinsic value, financial value versus strategic value, monetary versus economic value, emotional and psychic value, among others.  Environmental, social, and governance (ESG) value is relatively new, and gaining acceptance in corporate America.  Hedonic value has various meanings and uses but is usually thought of as the immediate emotional gratification (perhaps a cause for impulse buying), as contrasted to utilitarian value[2] (e.g., cars used exclusively for transportation).

Many people have heard of the cost, market, and income approaches to valuation, and these various approaches and hybrids can sometimes be applied to determining the different value standards mentioned above.  But while valuation (the process of putting a value on something) is part science and part art, there are well accepted techniques, methodologies, and theories that should be adhered to.  Valuation necessarily requires an understanding and deep insight into accounting, economics, and finance.  Now, statistical analysis, behavioral finance,[3] and cultural economics[4] are playing a more frequent role in valuation.

Fair Market Value

As the most common standard of value, it may be easiest to describe other value standards graphically as interrelationships and deviations from fair market value.  The plot below depicts utilitarian value against what I call cultural and emotional value.  Fair market value is generally high on the utilitarian scale (it represents the cash-equivalent price a buyer is willing to pay) and relatively low in cultural and emotional value.

Transcending Fair Market Value

Intrinsic and Fair Value

Intrinsic value can be related to psychic or emotional value but normally is thought of as the cash equivalent value (on a present value basis) to a specific owner.  That owner is usually the current owner and the value usually represents the value of the future cash flow, including the proceeds from a future sale.  Since taxes can be quite different in a sale (capital gains) versus income, normally an after-tax analysis is required to understand the scenario that may be more advantageous; hold versus sell.  But, once again, the owner may derive “satisfaction” and other rewards from being the owner/boss.  The tradeoff may be more than money, especially since the owner is incurring more risk.

I have placed the intrinsic value bubble above and to the right of FMV since the owner may have more time value (can realize income for more years and sell at a later date), all the while deriving more emotional or psychic benefits.

Fair value, like intrinsic value can certainly overlay (in the range of possible values) FMV and is normally calculated without regard to discounts associated with the lack of control and marketability.  The fair value of public stock is normally the same as its FMV.  In the case of closely held companies, the two can be markedly different because minority shareholders in private companies usually cannot sell their stock easily or control operations.

Transcending Fair Market Value

Liquidation, Monetary, Financial, and Strategic Value

 The liquation value is simply the FMV without the intangible assets of the business unless certain intangibles such as patents can be separately sold/licensed and utilized by another firm.  The monetary value is just what it says, pure cash value without regard to any psychic benefits.

To the typical private equity group (“PEG”), financial value rules – buy low and sell high.  It is all about cash-on-cash return.  A PEG usually requires higher returns (in part, to compensate for additional perceived risk since a seller will always know more than a buyer); therefore, the financial value is less than the expected monetary value (until they are a seller, of course).  PEG buyers also often look for market inefficiencies to achieve superior returns.  More often private equity buyers compete with strategic buyers (most often corporate buyers) in that revenue and cost savings synergies accelerate their value creation.

Transcending Fair Market Value

ESG and Psychic Value

Academic research has shown that incorporating environmental, social, and governance (ESG) considerations into the valuation of a company has (on average) a 9.8% increase on value.[5]  While adopting ESG can manifest into higher cash flows and/or growth for a company, we often see a significant portion of ESG value coming in the form of a reduction in the required rate of return (i.e., the cost of capital).[6],[7]  In fact, we see this reduction in the required rate of return bear out in the realized rate of return (i.e., the stocks of ESG companies have lower actual rates of return).[8],[9]  This begs the question: why do investors have a lower required rate of return for ESG companies?

It turns out that investors are willing to accept a lower rate of return when investing in ESG companies because of the non-monetary benefits they receive from investing in ESG companies.   The amount of additional benefit is buyer-specific, and while certainly related to the market price (FMV), the economic cost (which can be measured by how much return the investor is sacrificing for the given level of risk), plus the price paid would represent the total price the investor has in effect “paid.”  So, in my plot, I have placed ESG value to the right of FMV (higher cultural and emotional value) and below FMV (less utilitarian value).

Likewise, the sports car buyer or art collector is in a similar mode, getting to talk about the purchase, combined with the viewing pleasure (an additional attribute only relevant to physical assets).

Sports franchise investments often have similar characteristics.  Many do not make money, or at least not a fair return on investment.  In the case of certain franchises, though, the name recognition for the owner may lead to other opportunities that result in additional monetary value; or the owner may just derive a “psychic return” from the pleasure of being the owner of something so public and exclusive.

In fact, psychic return is a term of art in cultural economics.  It turns out that the actual returns on certain assets such as art are not commensurate with the risk inherent in holding the art (measured by their volatility over time in price).  It is this psychic return, the emotional gratification that comes from the ability to display, discuss (or brag), and view the art, which makes up for the missing return.

The sports car, fine art, and sports franchise examples may fall even farther than ESG value on the utilitarian axis, but to its right on the “psychic” scale.

Transcending Fair Market Value

On a more human and altruistic level, people all over the world work for less pay than their “opportunity cost” to take jobs that are psychologically rewarding.  Once I was asked to determine the economic loss associated with an injured, and scared, fashion model.  I recognized she lost more than her income; she lost the emotional rewards associated with being a model.  So, I conducted a survey to determine the amount of additional income it would take for the typical model to take a different job that she was qualified for, such as executive assistant (a job that today is almost obsolete) and added that to her lost income.

The Greatest of all Time (“GOAT”) Value

A paper on transcending value would not be complete without mention of the GOAT (aka, Tom Brady).  While Michael Jordan has arguably the greatest brand value in the history of sports, Tom Brady could compete for that valuation, should he want to.

Let us examine what has led to his value; Wins and Super Bowls!  And what has he done (other than be a great QB) to get there?  He has taken less than market salary and restructured his contract several times to surround himself by more expensive and presumably better teammates so that he can win.  So, he has derived huge psychic value at the expense of monetary value that could translate to enormous economic value, assuming he decides to fully monetize his success and fame.

Transcending Fair Market Value

I hope this short paper gets you thinking about the next major purchase, be it a business, a depreciable asset (like most cars), a perishable asset (such as a trip, although the psychic value created through memories can be high), or just something you have just always wanted.  In any event, it might give you some arguments with your significant other why you absolutely, positively need that sports car!

Questions and comments may be directed to Martin Hanan, CFA at 817-481-4900 or mhanan@valuescopeinc.com.

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping owners and executives in business transactions and estate planning.   Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago. 

[1]      Revenue Ruling 59-60, 1959-1 C.B. 237.

[2]      Babin, B., Darden, W., & Griffin, M. (1994).  Work and/or Fun: Measuring Hedonic and Utilitarian Shopping Value.  Journal of Consumer Research, 20(4), 644-656.  Retrieved March 26, 2021, from http://www.jstor.org/stable/2489765.

[3]      “Behavioral finance studies how people actually behave in a financial setting.  Specifically, it is the study of how psychology affects financial decisions, corporations, and the financial markets.”  Nofsinger, J. R. (2002).  The psychology of investing.  Upper Saddle River, NJ: Prentice Hall.

[4]      “…cultural economics is defined as the application of economic theory to the cultural sector…”  Towse,Ruth, 2019.  “A Textbook of Cultural Economics,” Cambridge Books, Cambridge University Press, number 9781108421683.

[5]      Willem Schramade (2016) Integrating ESG into valuation models and investment decisions: the value-driver adjustment approach, Journal of Sustainable Finance & Investment, 6:2, 95-111, DOI: 10.1080/20430795.2016.1176425

[6]      Lasse Heje Pedersen, Shaun Fitzgibbons, Lukasz Pomorski, Responsible investing: The ESG-efficient frontier, Journal of Financial Economics, 2020, ISSN 0304-405X, https://doi.org/10.1016/j.jfineco.2020.11.001.

[7]      Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltán Nagy and Laura Nishikawa, The Journal of Portfolio Management, July 2019, 45 (5) 69-83; DOI: https://doi.org/10.3905/jpm.2019.45.5.069

[8]      Morningstar shows that portfolios of companies with lower ESG ratings outperforms portfolios with of companies with higher ESG ratings.  https://www.morningstar.com/insights/2020/02/19/esg-companies

[9]      Lasse et al show that the lower returns are predominately from the environmental (E) and social (S) factors.  Higher ratings for the corporate governance (G) factor have been shown to result in superior returns.

Marty Hanan is the founder and President of ValueScope, Inc., a valuation and financial advisory firm that specializes in valuing assets and businesses and in helping business owners in business transactions and estate planning.  Mr. Hanan is a Chartered Financial Analyst and has a B.S. Electrical Engineering from the University of Illinois and an MBA from Loyola University of Chicago.

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.

Update on Oil & Gas Royalties Litigation-Key Valuation Issues

Click to Download:  Update on Oil & Gas Royalties Litigation-Key Valuation Issues

Executive Summary

Issue:  When oil and gas prices are lower than expected, royalties go down.  This is often when litigation picks up.  But the real issue has to do with a lack of clarity in the text of royalty and lease documents.  And this issue boils down to the valuation point, the physical location where the commodity or products are measured.

Challenge:   The Courts have produced a hodgepodge of rulings that tend to be specific to individual cases.  Cash is king, so if you can get to the actual, observable movements of cash through the value chain, then the value can be allocated properly.  It would be even better if lease and royalty documents were drafted more carefully!

Solution:  Map and model the actual cash flows penny by penny the same way that supply chain professionals map and model each step.  Oil and gas production is a supply chain that ends up in a place where the commodity is changed into something that is useful, like fuel, rubber, or natural gas that is dry and safe to burn in a power plant.  And let us keep our eyes on a critical case before the Texas Supreme Court – BlueStone v. Randle.

Royalties disputes and litigation are as old as royalties themselves, but they do ebb and flow with commodity prices.  Higher prices tend to mean that royalty owners are happy, and often do not scrub their royalty statements carefully.  Lower prices lead to a closer look, and that’s when the arguments begin.

What continues to be contentious here in Texas involves the text of how royalties are calculated and paid.[1]

  • What are the gross profits?
  • What is the market “at the well” valuation?
  • What are the production costs?
  • What does it mean to make oil or natural gas “marketable”?

It is true that oil and gas production involves complexities that other businesses do not have, and the gathering, processing, transportation, and marketing processes and costs can be opaque.  However, as a former treasury professional with two Fortune 100 energy companies, I can articulate that cash does not lie.  If the royalty and lease agreements are written better, to be very clear about how each and every movement of cash is calculated and accounted for, then there will be fewer disputes.

There are many royalty dispute cases in Texas every year, and this state’s Supreme Court has produced a body of rulings that are usually very linked to the exact language of specific royalty and lease documents.  Rather than go through this body of work, dating back to Heritage Res., Inc. v. NationsBank, 939 S.W.2d 118, 120-21 (Tex. 1996), I’d like to probe a case that is quite fresh: BlueStone Natural Resources II, LLC v. Walker Murray Randle, No. 19-0459.

BlueStone Natural Resources II, LLC v. Walker Murray Randle, No. 19-0459

The Texas Supreme Court agreed to hear this case on September 17th, 2020.  It is a very important case because it touches on two critical issues.  First, there is language in the leases, that was added in an addendum, that attempts to change the term on the original document from “market value at the well” to “gross value received.”  The second issue, which will be more and more critical as electric frac continues to grow, has to do with whether or not production from a well that is used as a fuel can be deemed “operations which Lessee may conduct hereunder.”  Electric frac means that the big engines used to force fluids into the ground (hydraulic fracturing), are gas-fired engines, and not the more common diesel engines.  Electric frac is growing because it is both more efficient, thereby cheaper, and better for the environment.

It will not just be Texans watching this case; various states around the nation that have oil and gas production in meaningful levels will also be watching.  This includes Ohio, Pennsylvania, Oklahoma, New Mexico, Louisiana, Colorado, and others.  It might be time to answer some key questions!

  1. Are “gross value received” and “gross proceeds” the same exact thing?
  2. If not, why not?
  3. Do either or both determine the actual valuation point for a sale?
  4. Is this the same as valuation point at a well?
  5. If not, why not?
  6. Are they observable, economically viable valuation methods?
  7. What is the difference between a valuation point at a well and a valuation point at the moment of a sale?
  8. How does title transfer of a raw commodity, an intermediate product, and/or a finished product; play into this debate?
  9. How can we draft these documents more clearly so as to avoid disputes, particularly when commodity prices are low? (I know, the Supreme Court is not going to give us the answer to this question!)

This case is a very significant case.  The oral arguments made last September really pointed out how so many previous decisions on these topics conflict and/or leave open significant issues.  We await with bated breath for a decision from the Court, and we shall see if the decision makes things clearer or continues to kick the can down the road.

Essential Valuation Factors

ValueScope assists clients by providing independent, third-party valuations that are generally triggered by an event, such as a sale, a buy, estate planning, tax work, GAAP application, bankruptcy, and litigation.  A short cheat sheet of the key valuation items we use to assess oil and gas royalties are summarized right here:

  • The Valuation Date or Dates
    • Get this clearly established at the outset.
  • The Purpose of the Valuation
    • What exactly is it for? Who will be reading it?  This will determine the Standard of Value; there are more than one.
  • The Standard of Value
    • “Fair market value,” is mostly used for tax purposes, but it is really the primary and most customary Standard in the USA. “Fair Value” is the US GAAP application standard.  Private capital firms use “Investment Value,” and a large part of this will usually involve exit assumptions.  “Intrinsic Value” is what equity research analysts use when they look at public stocks and bonds.  “Liquidation Value” is used for distressed situations and can be forced or orderly.  “Strategic value” is what you will see when big companies merge together, like when Shell acquired British Gas.  The large premium paid is based on a very long range, and quite permanent, model of the combined companies.  Using the proper standard of value is crucial to obtain an accurate determination of value and is necessary to avoid miscommunication in scoping the work upfront.
  • The Levels (Premise) of Value
    • Controlling interest basis means the value of the enterprise as a whole. It incorporates two components, the financial control level, and the strategic control level.
    • Marketable minority interest basis refers to the value of a minority interest, without control. It does, however, have liquidity as if it were freely tradable in an active market.  The marketable minority level of value is also valued on an enterprise-level of value, meaning that it is modeled on 100% of the expected cash flows of the enterprise.
    • Non-marketable minority interest basis means the value of a minority interest, that has neither control nor market liquidity.
    • Here is the point for this article-royalty interest owners do not own an interest in a business, so we view their interest to be either a marketable or non-marketable minority ownership interest in a business. This is often contentious because lots of royalty owners do not understand why their valuation must be subjected to discounting.  They do not control the drilling activity of the operator, and they have no voice in strategic direction or management decisions.  Plus, royalty interests are not marketable the way that shares in a publicly-traded company can be bought and sold easily.  If you want a valuation that has no minority discounting, then buy the entire company!
  • Important Industry Factors
    • There are no standardized rules for the valuation of oil and gas assets. The value of mineral and royalty interests is based on expected future cash flows generated by leasing and/or production, and this is driven by oil and gas market prices.  It is a price-taker business.
  • ValueScope considers and models a wide range of issues when we deliver this type of work:
    • Commodity Price Volatility
    • Technology
    • Basins/Access to Markets
    • Regulation
      • Treasury Regulations Section 1.611 – “the fair market value of an oil and gas property is the amount which would induce a willing seller to sell and a willing buyer to purchase.” Additionally, Section 1.611-2(g) outlines some considerations that a valuation of mineral properties must include for tax-oriented appraisals.
    • Well Economics
    • Financial & Strategic Condition of Operator
    • Working Capital
    • Leverage
    • Capital Budgeting and Drilling Plans
    • Break-even Analysis
    • Post-production deductions
    • The Asset-Based Approach
      • This approach is not useful for determining the value of royalty interest, and we do not use it. Usually, a royalty owner purchased land which included the mineral rights and an allocation of surface versus mineral rights was never done.  In other words, it can be hard to tell the cost basis of the assets, compounded by the fact that royalty interests are often family assets that are handed down for generations.  Captain King and his partner Gideon “Legs” Lewis bought a 15,500-acre Mexican land grant called the Rincon de Santa Gertrudis, and this started the King Ranch of Texas.  They paid $300; we cannot use that factoid in any meaningful way today for valuation purposes!
    • The Market Approach
      • The market approach uses comps, both trading and transaction. ValueScope uses direct comparable transactions of royalty interests if they are available.  However, they usually are not available, so the market-based approach is often not useful.
    • The Income Approach
      • ValueScope generally uses this method, by building a discounted cash flow analysis. We are experts with PHDWin software, and this allows us to customize the economics of the facts of the actual wells and the deal, making it a bespoke valuation.  We project production levels over the well portfolio’s useful life.  Revenue is based on both production and price; as such, we prefer to use simulation models to value over a range of oil, gas, and NGL prices.  Cash flows net of severance, ad valorem taxes, and other deductions is then discounted back to present value using a discount rate that is meaningful.  In other words, the traditional “PV10” number using 10% is not useful; it is too low.

Conclusion

BlueStone v. Randle is a big deal, and we shall see what it produces.  In the meantime, it is always best to find professionals who understand all the issues embedded on oil and gas royalties, including recent case history.  This is the only way to get this kind of valuation done properly.

ValueScope: Measuring, Defending, and Creating Value for Our Clients

ValueScope is a leader in the application of fair value measurement applying the Mandatory Performance Framework for better compliance with the Public Company Accounting Oversight Board.

For more information or to contact us for any need you may have, please feel free to write or call.  We look forward to speaking with you.

[1] https://www.rrc.state.tx.us/about-us/resource-center/faqs/royalties-faq/

[2] http://www.search.txcourts.gov/Case.aspx?cn=02-18-00271-CV&coa=coa02

Tom McNulty, CQF, FRM, MBA

PRINCIPAL AND MANAGING DIRECTOR, HOUSTON
tmcnulty@valuescopeinc.com

 

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

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Tax Benefits of the CARES Act to Energy Companies

Click to Download:  Tax Benefits of the CARES Act to Energy Companies

Executive Summary

Issue:  As the end of 2020 draws near, the benefits to energy companies of The Coronavirus Aid, Relief, and Economic Security (CARES) Act should be kept in mind for 2020 tax filings.  The CARES Act was signed into law on March 27, 2020, and includes broad measures to provide assistance, economic stimulus, and relief to American companies and individuals.  Certain measures included in the act are of significance to energy companies, particularly oil and gas upstream exploration and production companies which have faced difficulties in 2020 due to the drop in demand and commodity prices created by the COVID-19 pandemic.  Other energy companies such as renewable energy-focused companies may also find benefits as well.

Solution:  Key measures in the CARES Act that should be considered include the reinstatement of net operating loss (NOL) carrybacks, more lenient guidelines for the business interest deduction, and the treatment of intangible drilling costs. Valuation and analytical work in this industry need to be done by firms that have the requisite experience and technical ability, as well as a strong understanding of the industry specifics and value drivers. Generalists will make mistakes you cannot afford.

On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act which included a broad number of measures aimed at providing relief and economic stimulus to the United States economy in response to the onset of a global pandemic caused by the COVID 19 virus. Many oil and gas exploration and production companies had already been facing difficulties before the pandemic due to a price war between Saudi Arabia and Russia, leading to lower commodity prices. Certain measures of the CARES act could provide some real short-term benefit and liquidity to oil and gas companies as well as to other companies across the broader energy space. Below is a summary of some of the CARES Act provisions which could be of use to energy companies.

NOL Carrybacks

One of the most significant changes to tax law from the CARES Act is the reinstatement of the net operating loss (NOL) carryback provisions under IRC section 172 and the lifting of the 80% limitation on NOLs for future periods. The ability to apply NOLs to prior periods was removed with the passing of the Tax Cuts and Jobs Act (TCJA) in 2017, and it also limited application for future periods to only 80% of the operating loss. The new CARES act allows companies to carry back NOLs incurred in tax years 2018-2020 for up to five years, offsetting 100% of taxable income in those periods. Of particular advantage for oil and gas companies is the ability to apply NOLs incurred during periods of low commodity prices to those of higher commodity price environments, including periods where the prior 35% tax rate was applicable.

Sources of NOLs could be current year operating losses given lower commodity prices, as well as asset impairments for long-lived assets such as plant and equipment and oil and gas reserves, particularly those with shorter expected lives.  An oil and gas company with marginally profitable reserves in recent periods could support impairing those assets in the current environment, thus creating or increasing an NOL for the current year.  Additionally, oil and gas companies could review oil and gas leases, and impair the value and costs associated with any abandoned or expired leases. Lastly, the TCJA also increased the bonus depreciation percentage to 100% for qualified property acquired and placed between September 27, 2017 and January 1, 2023. As such, it might be possible and advantageous for oil and gas companies to utilize bonus depreciation in the current tax year in order to create NOLs to carry back, however the decision should also consider Management’s business outlook and as a consequence its assessment of the value of such depreciation in future years.  Receiving cash in the form of significant refund checks made possible by NOL carrybacks would be welcomed by a company seeking additional liquidity currently amid lower demand and commodity prices stemming from the COVID pandemic.

For renewable energy companies, accelerated Modified Accelerated Cost Recovery System (MACRS) depreciation could have additional value as facilities which came online in 2018 or 2019 could elect to apply NOLs stemming from the significant depreciation deductions associated within the first two years of the 5-year MACRS schedule to earlier periods when the 35% tax rate was in place. As mentioned above for oil and gas companies, renewable companies may also find value in utilizing bonus depreciation aside from accelerated depreciation for the purposes of utilizing NOLs.  For certain tax equity structures, these depreciation elections could increase the internal rate of return of the tax equity investment, resulting in earlier flip periods and higher overall cash investment returns than originally expected.

Business Interest Deduction Changes and Intangible Drilling Costs

In addition to operating losses stemming from lower commodity prices, oil and gas companies can also take advantage of changes in the deductibility of business interest costs. Another provision of the CARES Act was the change in the limitation of interest deductibility from 30% of adjusted taxable income to now 50%, however the change is only applicable to the 2020 tax year. As a result, certain energy companies with significant leverage may be able to better utilize interest costs as deductions and operating losses this tax year.

Oil and gas companies can also potentially create or increase operating losses by deducting intangible drilling costs (often in the form of wages, fuel, and supplies) which may be deducted or capitalized for tax purposes. If deducting the intangible drilling costs would not result in an operating loss that could be carried back and utilized to create refunds, companies should consider capitalizing the costs and deducting over a 5-year period, creating positive value as a deduction in a hopefully higher earnings environment.

ValueScope Can Assist You

Overall, the CARES Act includes several benefits to energy companies. ValueScope can assist your company in its tax and financial reporting requirements, especially when valuation and cash flow forecasting are at play, such as in the asset impairment process. ValueScope’s energy team provides services to clients operating across the entire energy industry, from oil and gas producers to renewable energy generators. Our expertise is deep and broad, which allows us to offer specific technical and industry insights and capabilities that cannot be matched by generalist firms. We have a rare combination of industry, banking, consulting, valuation, and government experience at ValueScope.  We understand all of the factors and drivers that move energy markets today.

For more information, contact:

Brad R. Currey, CEIV, CFA

DIRECTOR – ENERGY PRACTICE LEADER
bcurrey@valuescopeinc.com
Full Bio →

 

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

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ESG A Valuation Framework

Click to Download:  ESG A Valuation Framework

Overview

It started sometime last year, during the fourth quarter.  The morning business show Squawk Box began to mention “ESG” on a daily basis.  Sometimes it was one of the hosts, sometimes it was a guest. Then. there were two inflection points that marked a higher level of discourse.  First, on December 17, 2019, SEC Commissioner Hester Peirce went on live television to call for greater oversight of how ESG is used by companies and the investment community. 

The notion that we can come together and we can get our regulator to focus on an amorphous set of qualities other than the long-term financial value of a corporation, I think we’re fooling ourselves,” said Commissioner Peirce on CNBC’s Squawk on the Street

At the time, more than $17 billion had been invested into sustainable-focused exchange-traded funds (ETFs) and open-end funds during 2019.  In 2018, the number was about $5 billion.  “The first issue is that we don’t even know what ESG means,” Peirce continued.  As more and more ESG investing happens, there will be more and more scrutiny as to how a fund defines its ESG qualifications.  Pierce added “Not only is it difficult to define what should be included in ESG, but, once you do, it is difficult to figure out how to measure success or failure.”  

The second inflection point was triggered by the “Fundamental Reshaping of Finance” open letter to CEOs on January 14, 2020, by BlackRock Chairman and Chief Executive Officer Larry Fink.  “In a letter to our clients today, BlackRock announced a number of initiatives to place sustainability at the center of our investment approach, including: making sustainability integral to portfolio construction and risk management; exiting investments that present a high sustainability-related risk, such as thermal coal producers; launching new investment products that screen fossil fuels; and strengthening our commitment to sustainability and transparency in our investment stewardship activities.”1

What does this really mean?  Environmental, Social, Governance or “ESG,” is a term very few had heard of even two years ago. Today, ESG is not only a dominant topic of discussion across the American business and investment community, it is driving business decisions, impacting corporate structures and organizational charts and it is having a profound impact on investment decisions. Further, the recent global pandemic and economic crisis has accelerated the drive by companies to establish ESG programs, and report ESG metrics as they seek ways to attract investment capital and demonstrate rigorous ESG risk management in their organizations.

What has remained elusive for businesses and investors is a way to quantify the actual and potential risks, losses, benefits, and rewards associated with ESG decisions. Corporate leaders and boards have been missing a way to tie ESG to valuation. How do you justify making substantial investments and fundamental changes to corporate structures and culture without empirical evidence that it will make a direct impact on shareholder value, total shareholder return, net present value, and individual rates of return? 

These are fair questions.  Do ESG programs impact firm value?  If they do, how exactly can the valuation impact be measured?  What will need to be addressed by regulators that could allow this valuation impact to be reported?  Will ESG assets be recorded on balance sheets one day soon, just as intangible assets such as goodwill and intellectual property are recorded today?

Generally speaking, pre-COVID, the goal of ESG risk management was to minimize negative events that might impact value. That said, this lens of due diligence has changed how the market invests.

As it pertains to the energy sector, the weight energy carries in various indices has gone down significantly in the last few years. Clients are asking investors to keep their money invested in ESG compliant portfolios and think that fossil fuel-based companies contradict this investment thesis.  A factor of investment in the market is based on sentiment and belief in performance. If investors are more comfortable in ESG funds, then more people will keep their money invested in them.

That leads to another interesting aspect:  the psychological factor.  Given the benefits of ESG, investors are geared behaviorally to allocate their investments towards these funds. As companies continue to legitimately integrate ESG into business strategy, the ability to achieve “alpha,” which is an excess return or performance above a codified index or peer group, might become more difficult to do.

While we might not have an answer right now about the regulatory aspects of ESG reporting, this paper will introduce analytical methods for providing valuations of ESG performance.  Our framework is objective and designed to serve all constituents.  But even before we get to that, there are two essential steps that must be completed first.  Before you can value something, especially something that is intangible, you must define it.  After it is defined, it must be measured in a way that is transparent, auditable, and objective. Finally, the valuation should utilize vetted, established, and customary valuation techniques and metrics that have been used for years to value businesses and assets for decades.  There is no need to “reinvent the wheel.” We can value ESG assets and their impact on a business today.

Define

It is difficult to measure and value things that are not well defined.  While many might know that ESG stands for Environmental, Social, and Governance, that is often where the knowledge ends. Fixed definitions are hard to come by, and the scattering of websites, scorecards, speeches, podcasts, and white papers that mention ESG in many different ways do not help.  There are, however, certain established and respected frameworks that can and should be used now.  The most well-developed thus far is the one published by the Sustainability Accounting Standards Board (“SASB”).

SASB is a nonprofit organization founded in 2011 by Dr. Jean Rogers,2  SASB’s first Chief Executive Officer.  The roots of the SASB framework are based on a 2010 academic white paper written by Dr. Rogers, along with Steve Lydenberg, who was then the Chief Investment Officer of Domini Social Investments, and Dr. David Wood, who was then Director of the Initiative for Responsible Investment at Harvard University.  The paper, entitled “From Transparency to Performance: Industry-Based Sustainability Reporting on Key Issues,” was drafted to establish standards to be used in Securities and Exchange Commission (“SEC”) filings, such as 10Q or 10K reports.  The authors wanted to propose a methodology that would help investors, regulators, and analysts to understand specifically how individual companies and companies in funds compared in terms of social and environmental goals and issues.

The name SASB is no coincidence.  It was devised to sound like “FASB,” the Financial Accounting Standards Board.  The FASB originated in the summer of 1973 to organize and codify the US Generally Accepted Accounting Principles, (“GAAP”), are used by American companies, in conjunction with the American Institute of Certified Public Accountants, the “AICPA.” The SEC provided its imprimatur later that year, which gave the FASB and its research, pronouncements, and guidelines substantial weight and credibility.  In other words, in the US, the FASB makes the accounting rules that public and private companies use so that their financial statements are rules-based and consistent.

SASB3 seeks to replicate what FASB does by creating a set of clear disclosure standards broken out by environmental, social, and governance topics, and by industry.  At the heart of the SASB framework is its “Materiality Map®” or “Map.” Eleven industry groups are shown across the top, from Consumer Goods to Transportation.  Along the left-hand side of the Map are the 26 sustainability issues that the SASB has identified and selected which can be expected to impact financial statements and the operating performance of a company. They are summarized here, as referenced directly from the SASB website:4

Environment

  • Greenhouse Gas “GHG” Emissions
  • Air Quality
  • Energy Management
  • Water & Wastewater Management
  • Waste & Hazardous Materials Management
  • Ecological Impacts

Social Capital

  • Human Rights & Community Relations
  • Customer Privacy
  • Data Security
  • Access & Affordability
  • Product Quality & Safety
  • Customer Welfare
  • Selling Practices & Product Labeling
  • Human Capital
  • Labor Practices
  • Employee Health & Safety
  • Employee Engagement, Diversity & Inclusion

Business Model & Innovation

  • Product Design & Lifecycle Management
  • Business Model Resilience
  • Supply Chain Management
  • Materials Sourcing & Efficiency
  • Physical Impacts of Climate Change

Leadership & Governance

  • Business Ethics
  • Competitive Behavior
  • Management of the Legal & Regulatory Environment
  • Critical Incident Risk Management

By creating this framework, SASB seeks to “help businesses around the world identify, manage and report on the sustainability topics that matter most to their investors.”5  It is a smart strategy, because this work is happening in parallel to regulatory work that might evolve out from the Congress and the SEC.  SASB has developed a first mover advantage, and many companies and investor funds are already using the framework today.  BlackRock, mentioned above, publishes a SASB disclosure document, easily downloaded from its website.6  This very disclosure document highlights the fact that a company’s bottom line and its brand can be impacted measurably by environmental and social indicators. There is growing empirical evidence provided by academics, institutional investors, and consulting firms that has confirmed this.  Most recently, $1 of every $4 dollars is invested in the US today under an ESG/ SRI label.  In our view, it will be SASB and its framework that will drive this narrative.

In addition to SASB, there are two other organizations that should be noted in this context.  One of them is the Financial Stability Board (“FSB”) Task Force on Climate-related Financial Disclosures (“TCFD”), created in 2015.   TCFD’s stated mission is to “develop voluntary, consistent climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers, and other stakeholders.  The Task Force will consider the physical, liability and transition risks associated with climate change and what constitutes effective financial disclosures across industries.  The work and recommendations of the Task Force will help companies understand what financial markets want from disclosure in order to measure and respond to climate change risks, and encourage firms to align their disclosures with investors’ needs.”7

According to the TCFD, climate risk is financial risk that is non-diversifiable and can impact corporations through revenues, expenditures, assets and liabilities, and capital and financing. In 2017, TCFD released its report outlining recommendations for reporting climate-related risks. It organized those risks into the following categories:

Transitional Risks

  • Policy and Legal
    • Carbon pricing and reporting obligations
    • Mandates on and regulation of existing products and services
    • Exposure to litigation
  • Technology
    • Substitution of existing products and services with lower emissions options
    • Unsuccessful investment in new technologies
  • Market
    • Changing customer behavior
    • Uncertainty in market signals
    • Increase cost of raw materials
  • Reputation
    • Shift in consumer preferences
    • Increased stakeholder concern/negative feedback
    • Stigmatization of sector

Physical Risks

  • Acute: Extreme weather events
  • Chronic: Changing weather patterns and rising mean temperature and sea levels

TCFD’s recommendations are organized around four areas that represent how organizations operate: governance, strategy, risk management, and metrics and targets. TCFD provides recommended disclosures for these four areas and guidance on how to implement the recommendations for the financial sector ( banks, insurance companies, asset managers, asset owners) and the non-financial sector (energy, transportation, materials and buildings, and agriculture, food and forest products). It also provided a list of principals for effective disclosure.

Esg A Valuation Framework

TCFD disclosures provide transparency to the financial community on the climate-related risks a company faces. This is important because it gives the markets a realistic assessment of those risks. A key component of disclosure is demonstrating mitigation measures and efforts. When the financial community understands those risks in terms of impacts and ability and willingness to mitigate, it rewards those companies most organized and committed to mitigating those risks. By providing rigorous assessment of risks, including scenario planning, and by demonstrating forward thinking, actionable risk mitigation plans, companies can ease the concern financial institutions and the public sector may have for their climate-related risks.

The TCFD is critical because it is a global institution that has input from global institutions, financial and non-financial. SASB standards and TCFD recommendations are complementary. TCFD’s Implementation Annex extensively references SASB standards as an effective tool for implementing TCFD recommendations.

The United Nations’ Sustainable Development Goals (SDGs) were adopted by UN member states in 2015 as a universal call to action to end poverty, protect the planet and ensure that all people enjoy peace and prosperity by 2030. According to the UN, they are “the blueprint to achieve a better and more sustainable future for all. They address the global challenges we face, including those related to poverty, inequality, climate change, environmental degradation, peace, and justice. The 17 Goals are all interconnected, and in order to leave no one behind, it is important that we achieve them all by 2030.”8

The UN SDGs are becomingly increasingly import. Companies, especially those operating internationally, are encouraged to map their operations and performance to the SDGs and to disclose this mapping, along with SASB and TCFD mapping and disclosure.

Esg A Valuation FrameworkMeasure

What good is any of this if it cannot be quantified?  Eight years ago, an article in the Financial Times quoted the infamous management consultant Peter Drucker in the context of corporate reporting of ESG related topics: “What gets measured gets managed.”9  That was eight years ago!  If we posit that ESG can be defined, and has been defined, and that the SASB framework will either be that which is chosen by regulators, or at the very least, play a substantial role in its definitions, then we can move on to measurement.  We know what ESG is when we see it.

How do we measure it?  Most observers contend that this is hard to do, even impossible.  Perhaps the environmental category or “E” of ESG, can be quantified because methane and CO2 emissions, waste, water pollution, etc. can be measured volumetrically.  Companies are already reporting how much they have measurably cut their GHG emissions, add it is becoming more common.10 But how do you measure the “S” and “G” components of ESG? Why is this hard to do? We have some good news.  These things are not hard to measure.  And we owe the solution to the “Big Data” revolution that has that has occurred, sometimes quietly, over the past several years.

What is Big Data?  It’s about counting using more comprehensive and sophisticated techniques through advances in information systems.  Digitization plays a key role.  We live in an age where vast swaths of information have been digitized, rather than stored as paper.  Digitization means that counting can be done more quickly, efficiently, and accurately.  As long as the critical data needed to evaluate not just environmental categories, but the social and governance categories as well is accessible, then it can be processed and analyzed.  We contend that much of this information already exists inside of companies today, but has not been organized from an ESG perspective as yet.

A comprehensive process map for this kind of work is outside the scope of this paper, but we can provide an overview of the most standard tasker flow.

  1. Identification – The data pertaining to a specific ESG factor needs to be located, identified, and described.
  2. Harvesting – The data needs to be harvested or collected.
  3. Complexity – The complexity of the data needs to be evaluated. This includes an assessment of its size, how it is stored, if a particular language is used, and how the data is interrelated.
  4. Structure – How is the data structured? Is it numerical or verbal, or both?  Is it continuous or discrete?  These are important things to consider when using specific tools to sort and analyze the data.

The growth of different types of tools that are used today to manage and assess data are plentiful, and include such well-established ones like R, Python, MATLAB, SQL, MongoDB, and Tableau.

Referring to a project and study one of us was involved in with a different firm, several years ago, the data was harvested from the Client’s ERP system, and R was used to organize, clean, and study the data.  Sam Gafford and Derya Eryilmaz published the results of this project and study, and their outstanding work, in The Electricity Journal, back in in 2018.11

In this case, the task was to study the energy efficiency benefit for a specific product (the “Product”).  We used the client’s residential customer database with 15-minute interval data for the years 2014, 2015, and 2016.  These customers were spread across the Electric Reliability Council of Texas’ (ERCOT) competitive market territory. ERCOT is the entity that manages the electrical grid for about 85% of Texas customers. Depending on the product chosen and whether or not the customer received subsidies, customers were assigned to four categories.  “Conventional” customers were the most common type of customer.  “Budget” customers also used the product, but they received subsidies from the state.  “Cash Managers” were also product users with subsidies who chose to manage their spending more actively on electricity on a daily basis.  “Energy Managers” actively managed their spending on electricity like Cash Managers but were not subsidized. Once the populations were determined, two key problems were addressed.  The first was the potential for a small subset of super-users to skew the averages because of the asymmetrical nature of the distributions of consumption.  The second was the potential for a higher incidence of disconnections in one population group to cause us to mistake forced savings for behavioral changes.

To address the first issue, we identified several extreme energy users and excluded these outlier customers from the data, in addition to the customers who dropped the product in each year. An outlier customer was defined as a residential customer whose daily energy consumption was an order of magnitude greater than the median of the energy usage of the sample.

To address the second issue, we eliminated all zero-usage intervals when measuring the average usage for that interval by each population.  However, by eliminating zero-usage intervals from the averages, we could count only the customers who were on-flow and be assured that any energy efficiency found would be independent of disconnections.

Self-selection happens when customer choice for a given product is not truly random.  Because the client operated in a competitive marketplace, the product choice was not random and was not controlled.  Because of the features of the product, we expected it to appeal particularly to consumers who were credit-challenged.  We selected a random sample of the conventional customers, who were the most numerous.  We employed power analysis in R to determine the appropriate sample size for the conventional customer dataset to yield statistically meaningful results.

There are established methods to address self-selection bias in empirical analysis.  Two commonly used methods are the “matching method” and the “instrumental variable” approach.  We chose the instrumental variable approach, which assumes a strong correlation between an intermediate variable and the variable of interest, the decision to use the Product.

The instrumental variable approach is preferred mainly because, unlike the matching method which would have required us to impossibly justify and measure all determinative household characteristics, we were able to validate the instrumental variable with statistical methods.  An acceptable instrumental variable was highly correlated with the Product and not correlated with the customer’s energy consumption.

For the study, we assumed the product adoption rate was highly determinative of the decision to become a product customer.  Specifically, we defined customer adoption rate Adoptioni as the percentage of a given zip code’s client customers that selected the product. The adoption rate was highly correlated with the customer product preference and not directly related to customers’ energy consumption.  We employed a two-stage least squares (2SLS) estimation methodology.

In the first stage of the two-stage least squares estimation, we used the Adoptioni rate to predict a customer’s product choice, which is the variable called Treatmenti,t . This variable took the value 1 for the product customers and 0 otherwise.  Using the predicted Treatmenti,t from the first stage, we estimated average energy savings for Energy Managers and Cash Managers separately in the second stage of Regression Equation 1.  The estimated coefficient b1 on the Treatmenti,t variable represented the average daily energy savings per customer.

We also controlled for humidity and time fixed effects in the second stage of Regression Equation 1.

First Stage:

Treatmenti,t = ao + a1 Adoptioni + a2 Humidt + φt + τi,t

Second Stage:

kWhi,t = bo + b1 Treatmenti,t + b2 Humidi,t + φt + εi,t

Where i = customer;  t = day;

kWhi,t = Average daily usage of customer i on day d;

bo = Customer specific fixed effect (i.e., controlling for the customer characteristics that did not change over time such as house size);

b1 = Average daily energy savings for customers (i.e., Energy Manager or Cash Manager);

b2 = The coefficient that captures the impact of average daily dewpoint by customer zip code on average daily energy consumption;

Adoptioni = Product adoption rate by zip code (i.e., percentage). This variable was used as the instrumental variable to correct for self-selection bias;

Treatmenti,t =An indicator variable taking the value 1 if the customer was a Product customer or 0 otherwise;

Humidi,t = Average daily dew point by customer zip code that captures the humidity;

φt = Time fixed effects. This is a set of indicator variables that controlled unobserved factors that changed over time such as daily, monthly, and seasonal impacts on average daily energy consumption; and

εi,t = Identically and dependently distributed error term of the regression model.

It is important to note one limitation of this study is that we were not able include energy usage data for customers prior to becoming a product customer due to data limitations.

What happened with this fancy way of counting? The energy efficiency benefit of the product was confirmed. The most essential finding of this study is that the Product did have an energy efficiency benefit of approximately 9.6%, with an average 10.7% for conventional households, which constituted the great majority of households. This benefit was net of any reduction in consumption from disconnections. Energy efficiency stemmed from more engagement by the customer with his/her energy service. The product customer had more frequent communications about his/her usage and the associated cost, more granular information, and more real-time information. Beyond that, the product not only provided deeper information; it enabled a customer to relate his costs to his benefits in a timely and concrete financial transaction that made the communication “more real.”

The financial impact of this efficiency can be quite significant. An Energy Manager using approximately 14 MWh per year and paying 12 cents per kWh would save $183 per year from this efficiency. By way of example, if all residential customers in Texas switched to the Product, the savings would top $800 million per year if all residential customers realized a 9.6% efficiency benefit. Besides the energy savings, the efficiency could lower peak capacity requirements, meaning fewer expensive peaker plant generators would need to be maintained in the generation stack, which is also an area of future research. What if the 9.6% efficiency benefit comes out of coal? What is the emissions impact of this one simple product? How does this look from an ESG perspective?

Value

As ESG issues increasingly impact the financial performance of companies, there has been little agreement on how they impact valuation. Moreover, financial data, such as accounting statements, often do not provide the level or type of information needed to make sure that defined and measured objectives are appropriately considered. Such considerations inevitably lead to one central question: how do analysts or objective observers assign a proper valuation to a specific company, adjusted for ESG metrics? The good news is that now that ESG has become more mainstream, ESG metrics used in conjunction with more traditional financial metrics is making it easier to assess the ESG profile of a company, including its overall impact on valuation. For some C-Suite management teams and Board room executives, having the ability to assess valuation enhancements through specific ESG criterial becomes the most critical factor in deciding whether that company decides to implement an ESG program at all.

The first iterations of ESG metrics and investment criteria took a blunt and mundane approach to sustainable investing, by excluding controversial factors and issues or by aiming to deliver a particular benefit or impact. That is not necessarily the case anymore. Now that ESG has become more mainstream, just over the last 18 months, metrics have become more sophisticated and often make quantitative assessments in understanding what those metrics means. It is now possible to apply ESG considerations across a company’s activities and to quantify a defendable valuation of the ESG impact.

For example, in looking to the midstream industry, there are a set of metrics that can be used now to quantify ESG aspects of firm value. This industry generates significant quantities of greenhouse gases and other air emissions from compressor engine exhausts, oil and condensate tank vents, natural gas processing, and fugitive emissions, in addition to emissions from mobile sources. Air pollutants can have significant, localized human health and environmental impacts. At the same time, the management of fugitive emissions of methane (CH4), a potent greenhouse gas, has emerged as a major operational, reputational, and regulatory risk. Financial impacts on midstream companies will vary depending on the specific location of operations and the prevailing emissions regulations, and will likely include higher operating or capital expenditures and regulatory or legal penalties. Companies that capture and monetize, or cost-effectively reduce emissions by implementing innovative monitoring and mitigation efforts and fuel efficiency measures, could enjoy several benefits. These companies can reduce regulatory risks and realize operational efficiencies in an environment of increasing regulatory and public concerns about air quality and climate change, both in the U.S. and globally.

Specific financial impacts on midstream companies from their GHG and other air emissions could be of three types: 1) additional costs from regulations of GHGs or air emissions that aim to internalize the societal costs of emissions, 2) potential for generating additional revenues from capturing and selling GHGs like carbon dioxide and methane or generating electricity from methane, and 3) cost savings from enhanced fuel efficiency.  All of these elements impact cash flow, which is the core driver of the Income Method of valuation.

Facilities in petroleum and natural gas systems are required to report emissions from combustion, venting, equipment leaks, and flaring.  Given the significant contribution of petroleum and natural gas systems to global GHGs and other harmful air pollutants, the EPA introduced rules in 2012 for oil and gas companies to reduce emissions. These include, for example, requirements for new storage tanks at compressor stations to reduce volatile organic compound emissions by at least 95%.  Similarly, state-level legislation and regulations can also affect operations of midstream companies with significant GHG and other air emissions. As a result of California’s AB32 cap-and-trade system, several midstream facilities, including compressor and storage stations, are required to reduce emissions or buy carbon credits (or permissions to emit) from the market. Both reduction of emissions and purchase of credits pose additional costs to the industry. Regulations in this area are also constantly evolving, creating operational risks for the industry. For example, California is also conducting field measurements of fugitive methane emissions from natural gas distribution pipelines. The results of the study are expected to inform the cost-effectiveness of developing regulations specific to fugitive GHG emissions from these operations.  Violations of air emissions rules can lead to regulatory fines and penalties, including additional measures to control emissions that may entail increased operating costs or capital expenditures.

What is most salient in the context of valuation is that companies with significant GHG emissions could also face a higher risk profile, and therefore cost of capital, due to the uncertain nature of future (likely more stringent) GHG regulations.  In particular, growing concern over methane leakage are likely to increase future regulatory risks. The probability and magnitude of the impact of GHG emissions and other air emissions on financial results in this industry are likely to increase in the medium term.

More and more work is being done on the valuation aspect of ESG.  Two important papers use a top-down approach.  “ESG in Equity Analysis and Credit” analysis was published in 2018 by the PRI, the Principles of Responsible Investment arm of the UN, and the CFA Institute.13  Less than a year ago “Foundations of ESG Investing: How ESG Affect Equity Valuation, Risk, and Performance” was published in the Journal of Portfolio Management.14 Both papers, and there are others, proceed down a path that identifies quantified value enhancements at the company level from ESG programs.  They are top-down and address this issue from the perspective of risk.  They combine elements of the Income Method, which is cash flow based, and the Market Method, which is based on comparative analysis.  These approaches can be distilled into one central concept: adjusting the discount rate.

Obviously the lower the discount rate, the higher the valuation, all other items held constant.  Adjustments to Beta can accomplish this.  Beta measures systemic risk, and the performance of a company as compared with a broad index like the S&P 500 or the Russell 2000.  There are also methods to use Beta to assess a private company, if the Guideline Public Companies selected for the analysis, the “comps,” are chose properly.  For example, in a recent valuation we completed, the mean unlevered Beta of a group of 10 comps was 0.58.  The re-levered Beta for the private company we were valuing was 0.56.  But absent an assessment of the ESG components and metrics of the 10 comps, one by one then taken as a whole against the S&P 500, there was no way to adjust the Beta with adequate support.

Using Alpha, however, it could be done.  Alpha is an adjustment made to the Capital Asset Pricing Model (“CAPM”) as part of the calculation of the Weighted Average Cost of Capital, or “WACC.”  Alpha is unsystematic risk, unique to the firm undergoing valuation.  It is here that a specific adjustment can be made for ESG value.  As shown below, if the aggregate fair value of the company’s ESG program is 150 basis points, then the Alpha is reduced from 5% to 3.5%.  The valuation increases from $263.9 million to $271.5 million, implying that the hypothetical ESG program is worth almost $8 million.

Esg A Valuation Framework

But how do we support the adjustment to Alpha?  The time has come for ESG to be seen as an asset that can be defined, measured, and valued.

According to the CFA Institute, “Intangible assets are increasingly critical to corporate value, yet current accounting standards make it difficult to capture them in financial statements. This information gap can affect valuations for the worse.”15 The authors were not even talking about ESG Intangible Assets, or the potential for the identification and separation of ESG intangibles in the near term.  Their article provides and overview of intangible asset valuation and its challenges.

Intangible Assets lack physical substance but are not financial assets.  According to the International Glossary of Business Terms,16 Intangible Assets are, “non-physical assets such as franchises, trademarks, patents, copyrights, goodwill, equities, mineral rights, securities and contracts (as distinguished from physical assets) that grant rights and privileges, and have value for the owner.”  Brand can be an Intangible Asset as well, and the value of a brand can be enhanced if the brand is associated with ESG programs.  The problem is that U.S. GAAP only allows Intangible Assets to be recorded in a balance sheet if they have been acquired.  But regardless of when or if this might change one day, the valuation techniques that are used to value intangible assets can be used to value the impact of ESG on a company’s total value.

There are several methods that can be used to fairly value intangible assets, and we will look at five.  The first is the Relief from Royalty Method, or RRM.  With this technique value is calculated by using hypothetical royalty payments that would be avoided by owning an asset rather than have to pay for it via a license.  We use the RRM most of the time to perform valuations of trade and domain names, trademarks, software, and certain types of R&D.   It is unlikely that RRM can be used to value ESG at this time, there is not enough data available yet to isolate what a real royalty rate might be for that can be tied to a specific revenue stream and where data on royalty and license fees from other market transactions are available.

The Multiperiod Excess Earnings Method, (“MPEEM”), has more promise.  It is an income approach, using discounted cash-flow analysis. But instead of using the whole entity’s cash flow, with the MPEEM we will isolate the cash flows that we can prove are driven by specific ESG factors.  Usually the MPEEM is used for an intangible asset that is the main driver of a company’s valuation, but that does not have to be the case.  We often use it for customer and client related assets, but again, ESG is a new area of study and the MPEEM should not be ruled out.

A third approach is called “with and without,” or the Differential Income Model (“DIM”).  With this technique we value the company, and then revalue it with any and all ESG related factors removed.  The difference in fair value equates to the fair value of the ESG program.

Real Options modeling can also be used to value intangible assets and is most often a technique that lends itself to value that will accrue in the future, with some uncertainty.  For example, patents might have no value today, but could be very valuable in the future if developed.  Pharmaceutical intangibles are often analyzed this way.

Lastly, “Replacement Cost Method Less Obsolescence” can be used for intangible asset valuation, by calculating the replacement cost for the intangible asset if it were brand new, and then applying an obsolescence factor unique to the intangible asset.

Need for Valuation Under Mandated Disclosure

ESG disclosure is, of course, currently voluntary in the U.S., though pressure is increasingly mounting for larger, publicly traded companies to disclose. The lack of uniformity in ESG disclosures is a criticism that is being voiced by the financial community, by regulatory bodies, activist groups, politicians and even by companies that are expected to disclose. That lack of uniformity and a general belief by certain constituents and policymakers that great disclosure transparency is needed generally, is creating momentum for mandated ESG reporting.

In 2019, the House Subcommittee on Investor Protection, Entrepreneurship and Capital Markets held a hearing on ESG. Subcommittee Chair Carolyn Maloney stated during the hearing that “ESG disclosures often aren’t as detailed as they should be” and that they “lack a legalized framework.” For that reason, she noted that they are “difficult to compare across companies.”17

More recently, ESG language has appeared twice in stand-alone legislation. It even appeared in a version of The Emergency Supplemental Appropriations Bill that would provide another round of relief for the COVID-19 pandemic. In both cases, the language would require companies receiving federal aid for COVID-19 to provide disclosures that satisfy the recommendations of the TCFD. It is unlikely that this language will be enacted into law through these bills. However, once legislative language is introduced in a comprehensive bill that is supported by a party’s leadership, like the Emergency Supplemental, it is likely to appear again in different legislative vehicles. We should expect versions of this language to appear in future legislation crafted by House Democrats.

It is important to note that in recent history there are precedents for Congress enacting legislation to strengthen financial reporting requirements when perceived weaknesses are noted by Congress and the public. In 2002, the Sarbanes-Oxley Act (SOX) was signed into law to improve the reliability of financial reporting for public companies and restore investor confidence in the wake of the Enron, Tyco International and WorldCom scandals. SOX imposed strict new requirements on accountants, auditors and corporate officers, mandating senior corporate officers personally certify that corporate financial statements “comply with SEC requirements and fairly present in all material aspects the operations and financial condition of the issuer. By knowingly signing off on inaccurate financial statements, corporate officers are now subject to criminal penalties, including prison time. Similarly, the Dodd Frank Wall Street Reform and Consumer Protection Act was enacted to further regulate the financial services community following the financial crisis of 2008. It established several new government agencies assigned to oversee provision of the Act that further regulate and restrict banking practices, lending, speculative trading, and credit ratings.

Future scandals, financial crises, and events that erode public confidence and markets could also easily result in some kind of legislatively-mandated ESG requirement. A change in the control of Congress and the White House to the Democrats could also result in such a statutory mandate. The Joe Biden Presidential Campaign endorses “Requiring public companies to disclose climate risks and the greenhouse gas emissions in their operations and supply chains” is an important tenet in the Biden Plan for a Clean Energy Revolution and Environmental Justice.18

There are numerous, recent regulatory developments impacting ESG. In December 2019, an SEC Commissioner called for greater oversight of ESG. Earlier this year, the SEC’s Investors Advisory Committee issued a recommendation to create a disclosure framework for ESG investments—specifically citing the current lack of consistent comparable data in the marketplace. That report sets the stage for the SEC to issue more consistent reporting guidelines or perhaps requirements for reporting ESG.

In July 2020, the U.S. Government Accountability Office released a report that contains an overview of issues related to public companies’ disclosures of ESG information. This report examines, among other things, (1) why investors seek ESG disclosures, (2) public companies’ disclosures of ESG factors, and (3) the advantages and disadvantages of ESG disclosure policy options. The GAO analyzed 32 large and mid-sized public companies across industries to best reflect a broad market assessment.

In June 2020, the U.S. Department of Labor (“DOL”) proposed an investment rule that that would govern how private retirement plans — particularly those under the Employee Retirement Income Security Act (“ERISA”) — should be managed with respect to ESG criteria. Recognizing the proliferation of ESG-related funds and that lack of standards for what qualifies an ESG investment, the rule proposes a requirement that priority will be given to investments that maximize financial returns, as opposed to automatically incorporating ESG ‘socially-orientated’ goals. The proposed rule states what should be obvious, that the goal and benefit of an ESG investment should be to maximize returns to the investor. It also helps mat the case for further standardization of what qualifies as ESG investment.

The notion of mandated ESG reporting requirements would have seemed a big stretch two years ago, but today they appear quite possible if not likely. Legislative and regulatory forces, a growing need for standardized practices in what constitutes ESG investments, a need for standardized ESG reporting, and a growing need by investors to understanding climate-related risks and mitigation plans are all drivers for some sort of ESG mandated ESG reporting and regulation.

The emergence of such mandated reporting and standardization further necessitates the need for ESG valuation. If such reporting is required, regulators will need to understand the market and financial impacts of such requirements, investors will need to understand the impacts of those requirements on financial factors, such as shareholder value and stock price, and companies will need to understand that impacts of required reporting and ESG reporting on their performance.

Case Study: Certified Green Energy

An example of define, measure, and value is an emerging certification process for green energy. Certified green energy is something that energy customers, traders, transporters and suppliers have been increasingly interested in for years. As companies and consumers set and seek to meet low carbon goals, the carbon-content or green value of the fuels they consume becomes more relevant.

There are examples of “mark ups” for premium products that provide a societal good when it comes to the environment, and certainly when it comes to health. The proliferation of “organic” food labeling is an example. The public is increasingly avoiding foods that use growth hormones or those that constrain animals in pens or tight quarters. There is a strong movement against genetically modified organisms, due to both health and ethics concerns. Increasingly, a certain segment of society is willing to pay a premium for foods that are labeled as organic or “non-GMO” foods.  In this case, the definition and measurement has been established, and the Food and Drug Administration is the arbiter. Valuation has been set by the market-how much more does organic kale cost than non-organic kale?

The energy industry is also seeing labeling. For years, utilities and power marketers have been offering green energy alternatives that contain higher renewable content or lower carbon emissions. Lower emission transportation fuels are advertised and are being offered to certain customers. Increasingly, some customers are demonstrating a willingness to pay a premium for cleaner, greener fuels.

At the same time, companies are taking steps to analyze, disclose, and improve their ESG credentials. An important measure of ESG is disclosure of Scope 1, Scope 2 and Scope 3 greenhouse gas (GHG) emissions. Scope 1 emissions are direct emissions that come from a company’s owned or controlled sources. For instance, fuel combustion by a company as well as its vehicle fugitive emissions are Scope 1 emissions. Scope 2 emissions are emissions that come from purchased electricity, heat and steam. Scope 3 emissions are those that come from the supply chain, i.e. purchased goods and services, business travel, employee commuting, waste disposal, transportation, and distribution (upstream and downstream), etc. Green energy, consumed by companies, can improve their Scope 1 and Scope 2 emissions, and even Scope 3 emissions if they are utilized in the supply chain, thus improving ESG performance.

Green energy also creates opportunities for energy companies, all along the value chain. First, it can be deployed to win or keep market share. Second, it might be possible to charge an economic premium. And third, it can serve to improve their ESG performance, in terms of the “E” of ESG.

An example of a growing opportunity for certified green energy is natural gas. Once considered a clean-burning bridge fuel for renewables, natural gas is now being vilified as a dirty form of fossil energy. Methane, the major component of natural gas, is indeed a GHG emitter when it is released into the atmosphere. However, when it is used to create electricity and replace coal-fired generation, it is a major (if not the major) contributor to GHG reductions in the U.S. and has a much greater opportunity for contributions globally. There is a vast base of coal-fired power generation across Asia, that could be replaced with gas-fired generation.

The flaring of natural gas and venting of natural gas in the U.S. shale plays is not helping the situation. It is damaging the reputation of natural gas in the U.S. and globally. For instance, in Europe, which needs to import natural gas, governments and private sector purchasers of natural gas are looking at ways to guarantee that the gas they buy meets green standards. Companies do not want “dirty” gas from U.S. shale operations and the EU is looking at creating green standards (production and transportation data certification) for natural gas right now. Competition between U.S. LNG producers/exporters and exporters from Russia, the Middle East, and Africa is fierce.

Green gas certification could be a differentiator for American companies. There have already been some pilot programs in the U.S. for green gas labeling and transport. This work has demonstrated that certifications can be done and that transactions can take place. It is clear at this point that there is no standard for certification, but that attempts are being made to do so. There also appears to be a lack of alignment with established ESG factors, something that is would be attractive to all parties involved in a certified green gas transactions. Plus, it does not address the “S” and “G” elements of ESG.

Finally, there is a missing piece when it comes to the valuation of certified green energy. Obviously, the green energy premium will ultimately be established by supply and demand, i.e., what the buyer is willing to pay and what the seller is willing to sell it for. (Just as with organic kale mentioned above.) But other factors need to be considered on the front end of a green gas program. There needs to be an established value of the benefit that certified green gas brings to the buyer and the seller in terms of all ESG factors. That valued premium will set the state for certified green gas transactions.

There are three steps is the process of establishing a certified green energy program and marketplace, whether it is for natural gas, renewable electricity, hydrogen, renewable fuels, or other green energy products. They are:

  • Define green energy: There needs to be a clear and standardized definition of each form of green energy. The definition needs to reflect the qualification of factors that make an energy form green.
  • Certify green energy: A standard certification process needs to be established to certify that an energy commodity meets the criteria agreed upon for it to meet the green energy definition. This certification should be performed by a qualified third party that is attached to an academic institution and should be subject to an audit process.
  • Value green energy: A valuation process should be established to determine the value of certified green energy products based on their benefit and value from an ESG perspective. That valuation should be provided by a qualified, independent valuation firm that has the requisite energy, commodity, and intangible asset valuation expertise.

ESG Standardization

It has been widely reported that one of the shortcomings of ESG, as it is currently being applied, is the lack of standardization. There need to be a set of nationally and internationally recognized standards for what qualifies and ESG performance, what constitutes a green fund or a green bond or even green energy.

With this in mind, Cornerstone and ValueScope are embarking on a collaborative research effort with The International Research Institute for Climate and Society (IRI), at Columbia University. This collaboration will focus on addressing critical ESG issues through research and implementation. It will enable Cornerstone and ValueScope to offer their clients, and other participants in this research effort, a role in establishing best practices and standards, as well as taking part in critical research and facilitated discussions that will provide the structure for successful and sustainable future of ESG principles and performance.

Conclusion

Valuation work associated with ESG might be relatively new, but the techniques and tools necessary to perform ESG valuation already exist.  Both public and private companies can articulate their various ESG programs, policies, investment, and strategies using the SASB framework.  Advances in data science, underpinned by widespread digitization of information, make it far easier today to measure just about anything with the right effort and process.  And intangible asset valuation concepts, such that the MPEEM and DIM, can and should be applied to unique ESG cash flows.  ESG valuations can be used to reconcile and support an adjustment to the CAPM, then the WACC, via Alpha. ESG is important and valuable, but it will be even more valuable when it is clearly quantified and valued using conventional and customary approaches. A DEFINE-MEASURE-VALUE approach is the right way to tackle this important and challenging issue.

About the Authors

Jack Belcher serves as a principal for Cornerstone Advisory Services. He has over 25 years of experience in energy and energy policy. Jack provides strategic and tactical advice to energy and transportation companies and financial institutions, focusing on government relations, regulatory affairs, public policy, strategic communications, situational risk management, and Environmental, Social, and Governance (ESG) performance. He is also a founder and managing Director of the National Ocean Policy Coalition. Jack previously served as executive vice president of HBW Resources, LLC, regulatory affairs and policy manager for Shell North America’s Exploration & Production Division, and staff director for the U.S. House of Representatives Subcommittee on Energy and Mineral Resources. Prior to that, Jack worked for the Independent Petroleum Association of America, Hart Energy Publications, and Texaco Gas Marketing Inc. He holds a B.A. in Government from The University of Texas at Austin.

Paul Looney services clients in the upstream, midstream and downstream sectors on government, regulatory and strategic business matters. Paul works with Cornerstone’s clients to ensure that they are compliant with federal regulatory guidelines at agencies that include FERC, DOE, EPA, DOI and with statutory requirements borne from Congressional authorization and appropriation legislation. His expertise also includes working with state and federal regulators in the permitting of large-scale energy projects including inter and intrastate pipelines, CNG and LNG facilities and upstream oil and gas projects. His experience also includes the permitting of exports, such as crude, natural gas and various refined petroleum and chemical products. Previously, Paul was executive vice president of strategic development at HBW Resources in Houston, Texas and prior to HBW, was principal and co-founder of the Washington, D.C. lobbying firm, The Washington Capitol Group. Earlier in his career, Paul served as government affairs director at the American Institute of Aeronautics and Astronautics where he worked with the firm’s corporate members in pursuing defense and energy-related regulations and legislation. Paul began his career in government service in Washington, D.C. at the U.S. Department of Interior in Congressional Affairs at the Bureau of Land Management and later served as legislative assistant to U.S. Congressman Ed Royce (R-CA). Looney holds a B.A. from the University of Texas at Austin and an M.P.A. in International Affairs from George Mason University.

Tom McNulty leads ValueScope’s Houston Office and Energy Practice. His responsibilities include financial consulting, valuation analysis, transaction and dispute advisory, and expert testimony. Tom McNulty has 25 years of experience working across the entire energy value chain.  He draws on a rare combination of industry, banking, consulting, and government experience to provide his clients with transaction, financial advisory, litigation, and valuation opinion services.  Tom holds the prestigious CQF (Certificate of Quantitative Finance) and FRM (Financial Risk Management) designations and received his BA from Yale University and MBA from Northwestern’s Kellogg School with various honors.

Sources:

[1]  https://www.blackrock.com/corporate/sustainability

[2] https://rogersassociatesllc.com/index.php/about-me/

[3] https://www.sasb.org/

[4] https://materiality.sasb.org/

[5]  https://www.sasb.org/

[6] https://www.blackrock.com/corporate/literature/continuous-disclosure-and-important-information/blackrock-2019-sasb-disclosure.pdf

[7] https://www.fsb-tcfd.org/about/#

[8] https://www.un.org/sustainabledevelopment/sustainable-development-goals/

[9] “Calls for corporate disclosure of social impact,” Ed Crooks, Financial Times, June 17, 2012.

[10] https://www.nblenergy.com/climate-change

[11] “Can a daily electricity bill unlock energy efficiency? Evidence from Texas,” Derya Eryilmaz and Sam Gafford, The Electricity Journal, Volume 31, Issue 3, April 2018, Pages 7

[12] “ESG in Equity Analysis and Credit Analysis,” Matt Orsagh, Justin Slogett, and Anna Georgieva, UN-PRI and the CFA Institute, 2018.

[13] “Foundations of ESG Investing: How ESG Affect Equity Valuation, Risk, and Performance,” Guido Giese, Linda-Eling Lee, Dimitris Milas, Zoltan Nagy, and Laura Nishikawa, the Journal of Portfolio Management, Volume 45, Number 5, July, 2019.

[14] “The Intangible Valuation Renaissance: Five Methods, “Antonella Puca, CFA, CIPM, CPA and Mark L. Zyla, CFA, CPA/ABV, ASA, CFA Institute, January 11, 2019.

[15] https://www.nacva.com/content.asp?contentid=166#terms_i

[16] https://www.brinknews.com/the-us-just-had-its-first-hearing-in-congress-on-esg-issues-whats-next-on-the-agenda/

[17] https://joebiden.com/climate/

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

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Middle Market Private Equity M&A Activity – Q2 2020

Click to Download:  Middle Market Private Equity M&A Activity – Q2 2020

Executive Summary

Transaction Volume Shrinks

Only 31 transactions were reported in Q2 2020, bringing the total reported transactions in 2020 to 113.

Size Premium

Size became an even greater pricing consideration for the middle market as transaction multiple variances widened for acquisition targets above and below $50 million.

Debt Usage Decline

In Q2 2020, total debt to EBITDA fell to 3.3x from 3.9x the prior quarter. This 0.6x decline in total debt to EBITDA was attributed to a decline in senior debt to EBITDA, pushing the percentage of subordinate debt to total debt to 15.2%, up 2.4% from the previous quarter.

Media & Telecom Soars

In the first two quarters of 2020, transaction multiples for the media & telecom industry rose almost 30% to its highest level over the past five years. This was accompanied with substantial increases of transaction multiples in the distribution and manufacturing industries.

Based on our review of GF Data’s latest M&A Report, the reported results for Q2 2020 display a sizable decrease in completed deals, having about 40% of the completed deal volume compared with Q1 2020 and Q2 2019. As the first quarter fully submerged in the COVID-19 pandemic, Q2 2020’s results reveal interesting consequences. Despite the simple average enterprise value (EV) to EBITDA multiple remaining at 7.4x from Q1 2020, total debt dropped to 3.3x, down from the 3.7x – 4.0x range over the previous several of years. The percentage of subordinate (sub) debt to total debt averaged only 14.0% in 2020. This is down from the 2019 average of 19%.

Middle Market Private Equity M&Amp;A Activity - Q2 2020

In the first quarter of 2020, average EV/EBITDA transaction multiples increased for the larger companies in the $50 – 250 million enterprise value range and decreased for the smaller companies in the $10 – 50 million range. The increased market uncertainty likely caused a premium to be paid for the larger, and perceived safer, companies. Both smaller and larger companies’ multiples slightly increased in Q2 2020, maintaining the considerable spread in multiples between smaller and larger companies.

Middle Market Private Equity M&Amp;A Activity - Q2 2020

Industry Analysis

We analyzed industry average EV/EBITDA multiples of acquisition targets to gain a more in-depth understanding of how the market perceived industry risk and growth prospects as COVID-19 disrupted the marketplace during the second quarter. Approximately 80% of the reported deal volume comprises four industries: manufacturing, business services, health services, and distribution.

Middle Market Private Equity M&Amp;A Activity - Q2 2020

The average EV/EBITDA transaction multiple for health care services steeply declined to 7.0x in 2020 from 8.4x in 2019. The health care services industry has been negatively impacted in the short-run by the COVID-19 pandemic, as both practices and patients avoided preventative check-ups and elective treatments. To the contrary, the distribution industry average EV/EBITDA multiple increased to 8.5x, up from 7.0x in 2019. The distribution industry was valued extremely high in Q1 and Q2 2020 as consumer e-commerce presence and demand for deliver-to-door goods grew considerably. The manufacturing industry also increased to its highest average EV / EBITDA multiple over the past five years, up to 7.2x. The technology industry experienced a dip in its average EV/EBITDA valuation multiple to its lowest level since 2016. The retail industry average EV / EBITDA multiple was down from its 2019 high of 9.3x yet remained significantly higher at 8.9x than its 2018 average of 7.5x. The Media & Telecom industry average EV / EBITDA multiple soared to 9.0x in 2020 from its 2019 average of 7.0x. America’s dependence on robust internet connection and digital media and entertainment became even greater as much of the country began working from home and spending more leisure time at home in 2020. Business services industry average EV / EBITDA multiple remained approximately the same over the last five years.

For more information, contact:

Middle Market Private Equity M&Amp;A Activity - Q2 2020

Michael Hanan

ASSOCIATE
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The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

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How to Avoid Chapter 22 in Restructuring Work for Energy Companies

Click to Download:  How to Avoid Chapter 22 in Restructuring Work for Energy Companies

Executive Summary

Issue

It takes time and money to go through a Chapter 11 restructuring, so going through it twice in a couple of years is unwise and inefficient.  Recently, it has been an issue with companies operating in the energy complex.  The challenges and complexities of energy markets make reorganization plans hard to properly formulate.

Challenge

The challenge for counsel and financial advisors has to with the often-severe price volatility common to oil and gas markets.  Restructuring practitioners are usually generalists, and often do not understand commodity markets or their impact on cash flow and debt capacity well enough to make plans feasible.

Solution

Generalists will make mistakes.  The solution calls for advisors who have deep and broad energy complex expertise.  Regardless of “customary” practices, using simple deterministic models is a poor idea.  The cash flow analysis that is done to support the feasibility of a plan of reorganization should not be deterministic.  Rather, it should be probabilistic, or stochastic.  Decisionmakers, including the courts, should be provided with a stress-tested model.

“Chapter 22” is not a technical legal term.  And it is not really a new term.  In fact, there was a roundtable at the Harvard Law School in 20141 that focused on this very thing.  Chapter 22 refers to a situation in which a company that had gone through a Chapter 11 filing, and emerged, has gone back into Chapter 11 again in short order.  What are the causes?  The Harvard Law School panel featured some of the nation’s finest bankruptcy attorneys.  Harvey Miller, of Weil, Gotshal & Manges, said that increased “recidivism” in Chapter 11 filings was mainly due to distressed debt and securities investors, who effectively gained control of the debtor and its plan formulation process.  This means they do all that they can to get the plan of reorganization confirmed.  Sometimes the plan’s actually feasibility is not well scrubbed.2 Marshall Huebner, of Davis Polk & Wardwell LLP, pointed to other factors that can cause a subsequent Chapter 11 filing, such as the underestimation of an industry’s more permanent decline, or creditor pressure on the debtor to keep too much debt.3  Mark Roe, a professor at Harvard Law School, articulated that Chapter 22 filings are not that common, and represent less than 20% of Chapter 11 debtors.  He also suggested that it might not be a poor trade-off, if most of the firms that file again do well.4  We are not as sanguine.  Why not do it right once?  And for companies that operate in the Energy Complex, doing it right the first time means you need to pay attention to the fundamental drivers of commodity price volatility.

What Does the Law Say?

In looking in the U.S. Bankruptcy Code, Section 1129(a)(11) provides, “The court shall confirm a plan only if all of the following requirements are met: Confirmation of the plan is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor or any successor to the debtor under the plan, unless such liquidation or reorganization is proposed in the plan.”5  So how does Chapter 22 happen?  In the context of energy companies, it happens when the debt load post-restructuring is based on wishful thinking as to how oil and natural gas prices will behave in the months and years after emergence.  Very few workout practitioners run detailed analysis of pricing trends and the actual debt capacity of the restructured firm if and when commodity prices fall.

Why is Energy Different?

Commodities, including oil and gas, are far more volatile than other asset classes like fixed-income and equities.  We have discussed this in a separate article recently published on our site.6  WTI oil has an average annual volatility of more than 40%, and the NYMEX Henry Hub natural gas contract is even higher.

This chart, below, was prepared by the Texas law firm Haynes Boone,7 which has been doing outstanding work in recent years tracking oil patch bankruptcies.  Note that Ultra Petroleum is listed.  Ultra Petroleum filed for bankruptcy back in May of 2016, so this is its second filing in four years.  It came out of Chapter 11 in 2017 with nearly $3 billion in new debt.  We wonder what natural gas price assumptions were used at that time when the plan was approved.  Energy commodities usually do not follow lognormal random walks and should be modeled via simulation.  The processes they follow have similarities to ARMA–GARCH models. The reason for this is that oil and gas prices move with the volatility of their physical and financial markets, as well as complex density functions of future prices that incorporate price jumps or “shocks.”8

How To Avoid Chapter 22 In Restructuring Work For Energy Companies

Simulation Models

Attorneys, and judges, often call simulation models “speculative.”  Given the anniversary that just happened, of the atomic bombings of Hiroshima and Nagasaki, it is well worth noting that Monte Carlo Simulation was used at Los Alamos, New Mexico as part of the Manhattan Project.  Arguably, its modern form using randomness with discipline and rigor, in computational analysis, was developed there.  There was no other way for the experts at Los Alamos to estimate how far a neutron will go before it hits something that will cause energy to be released.  There is nothing speculative about this technique.  It was a tested mathematical process used then, to model fast neutron chain reactions.  And it is especially common now in the energy, economics, physics, and pharmaceutical professions.

The term “stochastic” has its roots in the Greek word στόχος, which can be “stókhos” or “stóchastikos” in English.9 One definition of the word is “to guess,” which is why some lawyers think it is speculative. However, it also means “to aim or target.”  This is how we use it in finance, economics, etc.  The modeling that is done as part of any restructuring process, and reorganization plan, should consider more sophisticated approaches.  In our view, practitioners need to:

  • Take the 13 week rolling cash flow model used during the workout process and expand it to five years.
  • Use sensible input assumptions, especially with distributions and probabilities that are based on reality.
  • Run commodity prices that consider mean reversion and actual volatility assumptions, not wishful thinking
  • Stress test the forward-looking cash flows and debt capacity; and make them as sober as possible.

The cash flows we isolate are tested for their ability to support debt, the new capital structure of the restructured firm.  The critical inputs, especially commodity prices, can be matched to levels of debt that can be supported given the range of potential outcomes.  This type of modelling allows for price jumps or shocks to be tested carefully as well.  It is important to note that we do not use this technique to reach one specific answer.  Probabilistic modelling provides real decision makers with a range in which they can negotiate and design a better capital structure for the most likely economic forecast.

Conclusion

There is no reason for any energy company to go through a “Chapter 22” process.  The tools, techniques, experience, and data are all available such that any plan of reorganization can be constructed to model risk adjusted cash flows.  Lawyers, the Courts, and financial participants will develop more comfort with simulation techniques the more they are used by advisory practitioners.  The results for the various stakeholders will be far improved.

ValueScope: Measuring, Defending and Creating Value for Our Clients

ValueScope is a leader in the application of fair value measurement applying the Mandatory Performance Framework for better compliance with the Public Company Accounting Oversight Board.

How To Avoid Chapter 22 In Restructuring Work For Energy Companies

Sources:

[1] https://blogs.harvard.edu/bankruptcyroundtable/tag/chapter-22/, Stephanie Massman (J.D. 2015).

[2] Ibid.

[3] Ibid.

[4] Ibid.

[5] 11 U.S.C. §1129(a)(11)

[6] “ESG-A Valuation Framework”

[7] HAYNES AND BOONE, LLP OIL PATCH BANKRUPTCY MONITOR, June 30, 2020, www.haynesboone.com

[8] “Oil prices — Brownian motion or mean reversion? A study using a one year ahead density forecast criterion,” Nigel Meade, Energy Economics, Energy Economics, Volume 32, Issue 6, November 2010, Pages 1485-1498.

[8] https://www.merriam-webster.com/dictionary/stochastic

For more information, contact:

Thomas J. McNulty CQF, FRM, MBA

PRINCIPAL AND MANAGING DIRECTOR, HOUSTON
tmcnulty@valuescopeinc.com

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.

Oil and Natural Gas Prices-Are They Sustainable at These Levels?

Click to Download:  Oil and Natural Gas Prices-Are They Sustainable at These Levels?

Executive Summary

Issue

There are three primary drivers that must be considered when looking at oil and gas prices.  First, they are commodities, and move with the complex economics of global supply and demand.  Second, they are very volatile.  And third, they can be significantly influenced by global, geopolitical factors.

Challenge

The challenge for anyone doing transaction, valuation, bankruptcy, and litigation work with companies whose cash flows are driven by oil and gas prices is that the analysis can be very hard to do.  Often short-cuts are taken, such as using flat price curves or minimal sensitivity analysis.  These simplifications can be disastrous.

Solution

The solution involves having a deep understanding of commodity market behavior and pricing as a prerequisite to engaging in any professional services exercise with energy companies.  Analytical work in this industry needs to be done by those firms that have this experience and technical ability, with an eye toward rational, not aspirational, commodity pricing as the basis of work product.

I can remember it like it was just yesterday.  We were doing modeling and valuation work for an independent, upstream E&P (exploration and production) company.  The valuation element was for equity compensation, for Accounting Standards Codification “ASC” 718 and Internal Revenue Code “IRC” 409(a) purposes.  The broader modeling aspect was treasury focused, to stress test the debt capacity of the business.  The front month West Texas Intermediate (“WTI”) contract was trading at about $105 per barrel, and we wanted to risk our cash flow model.  The Client said something to the effect “OK, go ahead and run an $85 oil case if it makes you happy.”  We all know how the story ends, a couple of years later.  WTI closed at $26.19 on February 11, 2016.

Natural Gas is no stranger to rapid price movements either, as anyone working in this part of the country knows.  Whenever there is a hurricane in the Gulf of Mexico, prices spike rapidly over assumptions that production will be cut because of the storm, lowering supply.

But we might be asking the wrong question with “Oil and Natural Gas Prices-Are They Sustainable at These Levels?” The answer is “yes,” as this short article will discuss.  But the real question should be “which price level assumptions for oil and gas should be used for valuation, lending, transaction, and capital investing decisions?”  We are probably right at those very levels now.  Hope is not a strategy, and it is essential for all of the various players in the oil and gas business to avoid the notion that we can expect prices to “go back up” or “be where we need them to be” or “return to normal.”  Oil and gas prices are trading where they should be trading, given market dynamics, so plan accordingly.

Supply and Demand

Crude oil is supplied and consumed globally. The U.S. Energy Information Administration (“EIA”) is an excellent source for data on a wide variety of economic information and analysis, including supply and demand, across the energy complex.  It is part of the U.S. Department of Energy (“DOE”).  For example, the most recent EIA newsletter highlights that “annual U.S. crude oil production will average 11.6 million b/d in 2020, down 0.6 million b/d from 2019 as result of a drop in drilling activity and production curtailments related to low oil prices.”1 This is a textbook supply/demand sentence.  Lower prices caused some producers to cut back, and this in turn lowered supply.  There is broad consensus that the COVID pandemic has pressed global oil demand downwards, and there is plenty of data that supports this thesis.  The EIA analysis also includes references to COVID.

The supply side is an important factor as well.  On March 9 of this year, oil prices dropped when Saudi Arabia boosted its oil production to challenge Russia for its failure to adhere to production quotas.  The Organization of the Petroleum Exporting Countries, OPEC, manages crude oil supplies via a quota system.  OPEC+ refers to a broader group of producing nations formed about three years ago.  Russia is the dominant non-OPEC player in OPEC+.  It is not a mystery where crude oil supply comes from, the challenge has to do with how quickly demand will return to levels seen before COVID.

Natural gas was traditionally not supplied and consumed globally.  It is typically shipped via pipelines, and this is hard to do (and too expensive) across the world’s oceans.  The Liquefied Natural Gas (“LNG”) industry developed to solve this challenge.  LNG is natural gas, or methane, usually with some ethane in it, that has been cooled to -260 degrees Fahrenheit.  Why?  Because at this temperature natural gas can be transported quite safely, because it does not have to be pressurized at this temperature.  It is not flammable or explosive in this state.  LNG can be moved in large ships to where it is needed, and then re-gasified to be burned as fuel.

LNG can solve a fundamental market supply-demand problem:  there is a lot of gas in places where it is not necessarily needed, and not enough gas in places that could use it for power generation instead of coal.  According to the EIA “the Henry Hub natural gas spot price averaged $1.63 per million British thermal units (MMBtu) in June.”2, due to low demand.  The so-called shale revolution here in the U.S. opened vast reserves of natural gas, and natural gas liquids, that exceed the demand needs here in the U.S.  Potential demand from abroad is real, if and only if the US can ensure that it will produce the gas and get it to Asia and to Europe.

Petroleum economics is a big, complex topic, and beyond the scope of this short article.  The key takeaways on the supply side are that the OPEC+ group of powers will continue to try to manage oil prices by controlling supply, offset to some degree by the rapid growth of production potential in the U.S.  Look at it as a rough, imprecise cap and floor structure.  If OPEC+ reduces supply, to drive up prices, more U.S. production will enter the market, thereby placing downward pressure on prices.  It’s not exact or clean, given that different grades of crude oil and refinery capacity play a role in the dynamic as well, but the broad theme is correct and should keep us in the trading range we are in now for the near-term.

As for natural gas, there is no shortage on the supply side.  This question remains: will gas-fired power generation in both the developing and developed world replace coal rapidly, such that demand pushes prices up?  Until Washington, Oregon, and California become more concerned about the climate, and allow the U.S. to send LNG directly to Asia through the West Coast, where it will replace and eliminate coal power plants, the outlook is flat for now.

Volatility

Commodities, including oil and gas, are far more volatile than other asset classes like fixed-income and equities.  Using data from the EIA, I have illustrated below just how volatile they can be.  The EIA data for WTI Spot, at Cushing Oklahoma, goes back to January 15, 1986.  From then until now, the average annual price volatility has been 44%, and this does not include the aberration in prices that happened this year when WTI closed below zero.  That episode highlighted the impact that financial trading can have on a physical market.  Note that the mean price during this period is $44, and the median is about $31.  Given that oil prices are a large driver of inflation, especially Producer Price Inflation, it is unwise to inflate oil or gas prices.  This is a form of double-counting and is also true of most other commodities.

This EIA data supports the contention that prices are sustainable where they are now.  Why do market participants talk about prices “recovering?” Recovering to what price level?  There is a good deal of evidence that suggests commodities are mean reverting, at least to some degree. If this is the case, then perhaps oil is reverting to its mean right now.

Oil And Natural Gas Prices-Are They Sustainable At These Levels?

Natural gas volatility has been even worse, although less so lately.  From January 20, 1997, to now, the Henry Hub contract has experienced very high annual volatility.  At this time, we are well below both the mean and median prices, and this is a direct result of the supply side.  Natural gas is being flared now in the U.S., which means that it is being burned at the well head rather than gathered and transported to markets.  The demand side of the supply-demand dynamic is insufficient, so gas is being wasted.

Oil And Natural Gas Prices-Are They Sustainable At These Levels?

Given this kind of severe volatility, for both oil and gas prices, it is inherently dangerous for market participants and their advisors to do valuation, lending, and deal work based on potential price upside scenarios.  The supply-demand balance in place now, coupled with price levels at or below long-term averages, supports the notion that current price levels are sustainable.  These implied prices are based on lognormal analysis, given that oil prices do not consistently behave lognormally, some deviation can be expected.  However, think of it this way, it is  a much longer distance to travel from current prices up to $90, than it is back down to $16!

Oil And Natural Gas Prices-Are They Sustainable At These Levels?

Geopolitics

Oil prices, far more so than gas prices, have been impacted by geopolitics for many years, as oil can be used as an economic weapon.  For example, in 1940 and in 1941, the U.S. took several actions that ultimately cut off Japan from the vast majority of its oil supply, to punish it for aggression in China and Southeast Asia.  In October of 1973, OPEC embargoed oil shipments to the U.S., as a direct result of President Nixon’s support for the State of Israel during the “Yom Kippur” or “October War.”  However, diversity of supply can mitigate oil being used as an economic weapon.  Earlier this year, when Iran fired missiles at American forces in Iraq, oil prices jumped by about 4%.  But that is not the point of the story.  The fact that they only jumped 4% points to the impact that U.S. oil production has had in the market.  Price spikes in the past, due to heightened tensions in the Middle East and Persian Gulf, were always much higher.  Oil and gas prices are sustainable at current levels because there is more diversity of supply than there was in the past.

Conclusion

There is a standoff to some degree right now, within the supply and demand structure of oil and gas prices.  WTI is trading right above $40 per barrel, and natural gas is below $2.00 per MMBtu.  These price levels are sustainable because the supply-demand balance is capped and floored between OPEC+ and the vast potential of U.S. reserves and production.  Volatility continues to be very real, and high, but oil and gas prices, like most commodities, usually display some elements of mean reversion, and we are at or below long term mean prices.  And while geopolitical shocks still can and will move oil prices, supply diversity has reduced this traditional impact measurably.  The trading range we are in now for oil and gas prices is sustainable and can be expected to remain consistent through the rest of the year.

ValueScope: Measuring, Defending and Creating Value for Our Clients

ValueScope is a leader in the application of fair value measurement applying the Mandatory Performance Framework for better compliance with the Public Company Accounting Oversight Board.

Oil And Natural Gas Prices-Are They Sustainable At These Levels?

Sources:

[1] US Energy Information Administration, Short-Term Energy Outlook, July 2020

[2] Ibid.

For more information, contact:

Thomas J. McNulty CQF, FRM, MBA

PRINCIPAL AND MANAGING DIRECTOR, HOUSTON
tmcnulty@valuescopeinc.com

The information presented here is not nor should it be treated as investment, financial, or tax advice and is not intended to be used to make investment decisions.

If you liked this blog you may enjoy reading some of our other blogs here.