Discount Cash Flow Valuation of Upstream Oil and Gas Investments

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Accounting for Uncertainty in Discounted Cash Flow Valuation of Upstream Oil and Gas Investments∗ by William H. Knull, III, Scott T. Jones, Timothy J. Tyler & Richard D. Deutsch∗∗

Valuing future income streams from the production of oil and gas is a welldeveloped discipline within the industry and among sophisticated investors. Valuations drive companies’ investment decisions and market transactions every day. In the context of resolving disputes, especially international ones, arbitral tribunals are frequently called on to perform a similar exercise: to determine a lump-sum damages award to compensate for the loss of an income-producing asset. Both the arbitrators’ decision and the

industry’s evaluation entail converting projected future net revenues of an incomegenerating property to present value. However, the details of how to make that

conversion remain arcane to the legal non-specialist who nonetheless must advocate or adjudicate a claim based on such calculations. Recent scholarship has made progress in illuminating the doctrines governing the award of compensation in international commercial and treaty-based arbitrations.1 Many

Based upon a paper originally published in the Journal of Energy and Natural Resources Law, Vol. 25, No 3, August 2007. ∗∗

William H. Knull, III, Mayer Brown LLP. Mr. Knull is co-chair of the International Arbitration Group of Mayer Brown LLP. Scott T. Jones, Senior Managing Director, Lexecon, an FTI Company. Dr. Jones is also head of the energy practice for FTI Consulting Inc. Mr. Tyler is counsel and Mr. Deutsch is an associate in the International Arbitration Group of Mayer Brown LLP.

E.g., T.W. Wälde & B. Sabahi, Compensation, Damages and Valuation in International Investment Law, TRANSNAT’L DISP. MGMT. (forthcoming); Irmgard Marboe, Compensation and Damages in International Law – The Limits of “Fair Market Value”, 7 J. WORLD INV. & TRADE 723 (2006); John Y. Gotanda, Recovering Lost Profits in International Disputes, 36 GEO. J. INT’L L. 61 (2004); W. Michael Reisman & Robert D. Sloane, Indirect Expropriation and Its Valuation in the BIT Generation, in 74 BRIT. Y.B. INT’L LAW 115 (2004); Louis T. Wells, Double Dipping in Arbitration Awards? An Economist Questions Damages Awarded to Karaha Bodas Company in Indonesia, 19 ARB. INT'L 471 (2003); Markham Ball, Assessing Damages in Claims by Investors Against States, 16 ICSID REV. – FILJ 408 (2001). The


of these articles are grounded in the Chorzów Factory decision or its national-law analogs and their common principle of restoring the injured party to the position it would have occupied had the wrong at issue never occurred. This scholarship has attempted to provide a universal analytical framework for determining the appropriate method for calculating compensation. However, because of the breadth of these efforts, many of the details that arise in calculating damages in a dispute over oil and gas properties, as well as other assets, remain unresolved. We will focus on one such critical detail. Specifically, we will analyze the procedures essential to the Discounted Cash Flow (“DCF”) method of valuation for accounting for uncertainty in the life of a project and the risk that projected lost revenues would not have been earned as projected. The problem is familiar and can have an

enormous impact on value, especially for projects located in regions where disputes are likely to arise. Under economic and financial theory, the proper method for accounting for risk is clear. But, as reflected in the relatively few reported cases to have addressed the issue squarely, that theory in important respects and in the circumstances of many hydrocarbon investments lacks objective processes, criteria and/or data to guide parties, counsel and tribunals in its systematic and predictable implementation in the context of individual disputes. The result can be a lack of transparency and a substantial range for

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