During the period of the 1980's and 1990's the oil business endured or, at times, benefitted from several economic cycles which brought about extreme fluctuation in the prices for oil and gas, changes in interest rates from as low as 3% to over 20%, substantial declines in domestic U.S. production and continually increasing regulation of the physical and economic aspects of the industry worldwide. This paper will examine the effects of the cycles in prices, interest rates, regulation and other economic factors on the process and component of the valuation of oil properties for sale/acquisition, taxes and litigation and other purposes. The paper will draw on information developed as part of recent analysis work as well as published studies and SPE papers from the past 30 years. Specific areas of study and discussion will include the effects of various methods to identify and account for risk and the influence of interest rates on discount rates.
Economic cycles come in all shapes sizes, and durations. Economic cycles may coincide with business cycles or they may not. Economic cycles can be general and have an impact on all industries in the broad economy or they can be limited to a segment of the general economy. It is not unusual to have changes in the "economy" of the auto industry or the steel industry; there is currently both a general recession and a particularly strong downturn in the so-called "tech" sector of computers, software and semi-conductors. Economic cycles are common in the oil and gas industry. In many cases, the cycle can be shown to have an impact on the industry as a whole or, only the effect may be limited to an industry segment such as the natural gas or refining and not necessarily production.
The term "cycle" suggests economic events that, while resulting in changes over a period of time, end with conditions similar to, if not the same as, the conditions existing at the start. Of course not all cycles are uniform; they do not return to the starting point. The U.S. economy is currently going through a recessionary cycle which one hopes would end with business back to where it was in early 2000 or a bit better. The cycle is marked by declining incomes, increased unemployment, and slower growth in production. The largest component of the recession is, arguably, the decline in personal wealth caused by the sharp decline in the stock market followed by the decline in corporate value measured by stock prices as well as a decline in fixed income to a portion of the society due to falling interest rates.
What are the elements of an economic cycle? For the economy in general the elements include:
Equity Returns (Dividends + Growth)
Many more items could be added to the list but most would be included within one of the above. Indeed, changes in any one of the items listed could change some or all of the others. In a dynamic economy it would be expected that an increase in interest rates could reduce inflation, increase savings, cause equity returns to decline and, in the extreme, bring about political change.
The economic cycle is also known as the business cycle. In the context of this discussion we will view the effect of changes in the economy on certain aspects the oil and gas industry in general and on the valuation of oil and gas properties in particular. Our data will be interest rates, inflation figures, stock market returns and other information. We will consider if and how the elements of the economic cycle individually and/or collectively influence the valuation and the value of oil and gas properties over time. We will also examine some of the trends that may occur or appear to occur in the market for oil and gas properties.