SPE-201348-MS

The Effect of Margin and Reserves/Production Ratio on Oil and Gas

Transaction Multiples

Ronald Gajdica, EIG Global Energy Partners; Randall Byrne, Citi Global Energy Group

Copyright 2020, Society of Petroleum Engineers

This paper was prepared for presentation at the SPE Annual Technical Conference & Exhibition originally scheduled to be held in Denver, Colorado, USA, 5 – 7
October 2020. Due to COVID-19 the physical event was postponed until 26 – 29 October 2020 and was changed to a virtual event. The official proceedings were
published online on 21 October 2020.

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Abstract
Precedent transaction multiples are often used to estimate the market value of oil and gas assets. The
multiples typically used for valuation include production, reserves, and cash flow multiples. Improper
application of these multiples can lead to valuation estimates that are significantly different than actual
market value. This paper outlines a method to improve the accuracy of market value estimates from multiples
analysis by incorporating (1) the correlation between multiples and proved reserves to production ("R/
P") ratio, and (2) the effect of profit margin ("margin") on transaction multiples. The effect of margin is
especially relevant because some transaction metrics are not necessarily valid in the current market due to
significant changes in commodity prices.
Economic runs for a variety of conditions were made to observe the theoretical effect of R/P ratio, margin,
and discount rate on net present value. The net present value at a 10% discount factor ("PV10") was used as
a proxy for market value. Then, production, reserves, and cash flow multiples were calculated and analyzed.
Relationships between the different variables were studied, and equations to calculate the various multiples
as a function of R/P, margin, and discount rate were constructed. Comparison of multiples generated from
discounted cash flow ("DCF") regression analysis to actual transaction data show that the shapes of the
various curves generated agree with the historical trends.
This paper also includes commentary on how to correctly apply the multiples to asset valuation, equations
to calculate the various multiples, and a discussion of pitfalls to avoid when performing multiples analysis.

Introduction
A series of DCF economic runs was made using synthetic decline curves with different R/P ratios, profit
margins, decline rates, and products. Both exponential and hyperbolic decline curves, and oil and gas
products, were analyzed, and a family of curves was generated for each case showing the effect of R/
P and margin on the pertinent multiple. The results are similar to the empirical correlation to R/P, with
production multiples and cash flow multiples increasing with R/P, and reserves multiples decreasing with
R/P. The results also show the significant variability in value due to margin. Interestingly, the cash flow
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multiple curves collapsed to a single curve using the margin concept. Regression analysis was used to derive
equations that calculate multiples as a function of R/P, margin, decline rate, and product.

Construction of Multiple Concept

When an oil and gas asset is bought or sold, some market value is ascribed to the transaction. Assets
with higher production, reserves, and cash flow generally have more value than assets with lower metrics.
Industry analysts and business development professionals routinely evaluate the economic merits of a
transaction by calculating multiples based on these metrics.

Reserves Multiple
The reserves multiple is the ratio of the transaction purchase price to the reserves associated with the
transaction, and has units of $/boe or $/Mcfe. The denominator of this multiple used in this work is Proved
reserves, as is common in most instances. However, the denominator is somethimes 2P reserves, especially
for international transactions. Proved reserves includes the Proved Developed Producing, Proved Developed
Non-Producing, and Proved Undeveloped reserves categories. The reserves are the volumes remaining to
be economically produced as of the effective date of the transaction, not the effective date of the most
recent reserve report. Also, since reserves volumes depend on economic assumptions, the Securities and
Exchange Commission ("SEC") reserves guidelines are typically employed. Assets typically have multiple
hydrocarbon products such as oil, gas, and natural gas liquids ("NGL").
The reserves value used in multiples analysis consists of an "equivalent" volume that combines all of the
hydrocarbon products into a single parameter. Either gas or liquids (oil, condensate and NGLs), whichever
is dominant, is chosen to be the reference equivalent, and the non-dominant product is converted into an
equivalent unit of the dominant product.
For example, if an asset is predominantly gas, the liquids reserves are converted to equivalent gas reserves
using a conversion factor of 1 bbl = 6 Mcf. Thus, the reserves will be the gas reserves, measured in cubic
feet (Mcf), plus the equivalent volume of the liquids, measured in cubic feet equivalent (Mcfe).
Likewise, if an asset is predominantly liquids, the gas reserves are converted to equivalent liquid reserves
using the 6:1 conversion factor. In this case, the reserves will be the liquid reserves, measured in barrels
(bbl), plus the equivalent volume of the gas, measured in barrels of oil equivalent (boe).
The 6:1 conversion factor is based on the approximate energy value equivalency between oil and gas.
This factor is traditionally used to convert to equivalent volumes, even though the economic value of the
various products may differ significantly from this factor. If an asset has reserves split approximately equally
between liquids and gas on an equivalent basis, it is recommended that multiples analysis be done both
ways, as a gas and as a liquid, and the results averaged.

Production Multiple
The production multiple is the ratio of the transaction purchase price to the producing rate of the asset, and
has units of $/(boe/day) or $/(Mcfe/day). Similar to the reserves multiple, a dominant product is chosen,
and non-dominant product production rates are converted to the units of the dominant product using the
6:1 conversion factor.
Ideally, the production rate used to calculate the production multiple is the production rate on the effective
date. However, unless the production rate is stable and smooth, an alternative approach is usually employed.
Production rate for an asset can be quite variable when examined on a daily basis. This can be due to a
number of factors, such as pipeline curtailments, plant upsets, facility downtime, well downtime, or due
to flush production after a shut-in period or the drilling of new wells. A period of time that yields a more
representative production volume, such as the most recent one-month or three-month average, is often used.
Longer periods, such as the most recent 12-month average, are typically not used because systemic field
SPE-201348-MS 3

decline begins to have an effect on production rates when the period approaches one year, causing the
production rate denominator to be too large.

Cash Flow Multiple

The cash flow multiple is the ratio of the transaction purchase price to the annualized (12-month) cash flow,
and is dimensionless. The annualized cash flow can be calculated using the most recent available month,
an average of a number of recent months, or the trailing 12 months. In certain instances a future period
may be used. The option using the most recent relevant month(s) is most often utilized because it is more
indicative of the actual cash flow rate at the time of the transaction. For example, if the most recent month
of cash flow is used, it would be multiplied by 12 to annualize it, then divided into the transaction price to
calculate the cash flow multiple. Cash flow values are typically sourced from a Lease Operating Statement
("LOS"). Analysts should be aware that the last one to three months of a LOS may be incomplete or skewed
due to the delay of payment of bills, receipt of revenues, or prior-period accounting adjustments. Thus,
additional information and judgment is often required to select the appropriate period that is representative
of current cash flow.

Effect of Reserves to Production Ratio

The market value of an oil and gas asset with a given rate of production, volume of reserves, and rate of
cash flow can vary significantly. One of the primary variables impacting the value of an asset is the rate
of production decline.

R/P Ratio
The rate of decline and producing life of an asset can be quantified as a Reserves-to-Production Ratio ("R/
P"). This ratio is calculated by dividing the Proved reserves by the annualized production rate, and will
have units of years. For example, Mcfe / [(Mcfe/day)*(365 day/year)] = years. High R/P assets have a low
rate of production decline, large reserves volumes, and low production rate (reserves are produced slowly).
Low R/P assets have a high rate of production decline, small reserves volumes, and high production rate
(reserves are produced quickly).

Effect of R/P Ratio on Reserves Multiple

The value of reserves that are quickly recovered (low R/P) is higher than the value of the same volume
of reserves that take many years to be recovered (high R/P). This is because of the time value of money
concept, which is the basis of DCF analysis1. Assuming no changes in prices or costs, acceleration of
reserves into earlier years of a project provides an associated acceleration of cash flow, and increases present
value because of the effect of discounting. Thus, for a give volume of reserves, a low R/P asset has more
value, and a higher reserves multiple, than a high R/P asset because the reserves are recovered more quickly.

Effect of R/P Ratio on Production Multiple

The value of current production is higher if the production is from a low-decline and long-lived asset,
relative to production that is from a high-decline and short-lived asset. The low-decline asset will deliver
a larger volume of product over time than high-decline asset. For a given production rate, a high R/P asset
has more value than a low R/P asset.

Effect of R/P Ratio on Cash Flow Multiple

The value of cash flow is related to and behaves similarly to the value of production. The value of current
cash flow is higher if the cash flow is derived from a low-decline and long-lived production profile, relative
to cash flow that is derived from a production profile that is high-decline and short-lived. Cash flow based
on a low-decline production profile will deliver more money over time than cash flow based on a high-
4 SPE-201348-MS

decline production profile, assuming prices and costs are equal. For a given cash flow, a high R/P asset has
more value than a low R/P asset.

Typical Transaction Multiple Construction

Figures 1 and 2 display calculated transaction multiples from actual industry gas-weighted transactions.
Figure 1 shows the typical construction of the reserves multiple as a function of the R/P ratio for gas
transactions. The reserves multiple is generally higher for assets with a low R/P ratio, and the reserves
multiple decreases as the R/P ratio increases.

Figure 1—Actual reserves multiple as a function of R/P for gas transactions

Figure 2—Actual production multiple as a function of R/P for gas transactions

Figure 2 shows the typical construction of the production multiple as a function of the R/P ratio for
gas transactions. The production multiple is generally lower for assets with a low R/P ratio, and the
SPE-201348-MS 5

production multiple increases as the R/P ratio increases. Cash flow multiple behaves in a manner similar
to the production multiple.
In both Figures 1 and 2, the data points are scattered. It is easy to see that, although a general correlation
does exist, the scatter in the data is quite large, and a given individual transaction may or may not conform
to the general trend line. There are many reasons that cause the scatter:
1. Commodity product index prices are different
2. Commodity differentials are different
3. Operating costs are different
4. Gathering and transportation costs are different
5. Severance and ad valorem taxes are different
6. Royalty burden is different
7. Mix of developed and non-producing/undeveloped reserves is different
8. Mix of oil, gas, and NGL's is different
9. Unquantified upside may or may not exist
Construction of the multiples plots can be modified in a way that takes some of these variables into
account, which will improve the market value estimate and the use of multiples.

Economic Runs to Support Multiples Analysis

The market values that are reflected in the historical transaction data is representative of the intrinsic value
of the reserves, production, and cash flow of the asset. Another way of estimating the market value of an
oil and gas asset is to use DCF analysis. The cash flow forecast generated in DCF analysis is based on
assumptions regarding production volumes, product prices, capital and operating costs, and production/ad-
valorem taxes (excludes federal income tax). Variations over time for each of these variables are considered,
and the resulting cash flow stream is discounted to a present value using a discount factor. A commonly
used discount factor is 10%, although higher or lower discount factors may be appropriate.
A series of economic runs was made for a series of synthetic decline curves with different R/P ratios,
profit margins, decline rates, and products. Both exponential and hyperbolic decline curves, and oil and gas
products, were analyzed. The type curve inputs are shown in Table 1.

Table 1—Type Curve Inputs

Exponential Hyperbolic (b=1.5)

Gas Initial Rate (MMcf/day) 10 10

Oil Initial Rate (bbl/day) 100 100

Net Revenue Interest (%) 85 85

Working Interest (%) 100 100

Annual Decline (%) 2 – 50 5 – 90

R / P Ratio (years) 1.2 – 36.5 0.9 – 22.6

In an effort to account for commodity price, product differential, operating costs, gathering and
transportation costs, taxes, and royalty burden (items 1-6 on the list above), a margin approach was used.
Margin is the net-back price received at the point of custody transfer, less all applicable costs, calculated on
a unit of production basis. It is impacted by commodity price, product differential, taxes; operating costs,
gathering and transportation costs; and royalty burden, all of which can be collapsed into and represented
by the margin concept. The market multiple for a given reserves volume or production rate, and a given
6 SPE-201348-MS

R/P ratio, can differ significantly for similar assets that have different margins. For example, the reserves
for an asset with an R/P of 10 may be more valuable or less valuable depending on operating cost. If the
operating cost is high, the reserves would be less valuable; and if the operating cost is low, the reserves
would be more valuable. The same would be true for taxes, product differentials, gathering/transportation
costs, and royalty burden. Likewise, if a historical transaction was executed at a time in which commodity
prices were high, the reserves would be more valuable than the same reserves at a time when commodity
prices were low. The differences can be significant, and account for much of the scatter that is observed on
the typical multiples plots discussed earlier. By making economic runs that account for these differences, a
better correlation to historical data, and therefore better estimates of market value, will be achieved.
In order to investigate the effect of margin on transaction multiples, a series of type curves was generated
with different margin assumptions. A royalty burden of 15% was assumed for all cases. A gas index price of
$4.00/Mcf and an oil index price of $70/bbl were assumed, but the index price alone is not really important.
It is the calculated margin that matters in the economics. The unit margin is simply the index price less the
unit operating cost, gathering cost, tax, differential, and royalty.
For all of the economic runs, the net present value using discount rate from 6 to 20% was calculated.

Synthetic Multiples
The results of the economic runs were used to create synthetic multiples, using the calculated net present
value as a proxy for transaction value. For the production multiple, the net present value discounted at 10%
("PV10") was divided by the initial rate. For the reserves multiple, the PV10 was divided by the reserves.
This was done for a variety of R/P ratios and margin values.
The resulting series of synthetic multiples for the gas cases are shown in Figures 3 and 4. The results for
the oil cases are shown in Figures 5 and 6. As expected, the synthetic multiples show that low-decline, high-
R/P production profiles have higher production multiples and lower reserves multiples than high-decline,
low-R/P profiles. It can also be seen that margin has a significant effect on value. For example, on the gas
plots, it can be seen that cases with a gross margin of $2.50/Mcf are about twice as valuable as cases with
a gross margin of $1.50/Mcf. These results indicate that an R/P regression alone can produce error of over
100% if margin is not considered.

Figure 3—Synthetic production multiple as a function of R/P and net margin for gas transactions
SPE-201348-MS 7

Figure 4—Synthetic reserves multiple as a function of R/P and net margin for gas transactions

Figure 5—Synthetic production multiple as a function of R/P and net margin for oil transactions
8 SPE-201348-MS

Figure 6—Synthetic reserves multiple as a function of R/P and net margin for oil transactions

For each economic scenario, a range of discount rates were used to calculate present value. The discount
rate can be used to effectively shift multiples higher or lower for each family of curves. For example, Figure
7 shows a plot of synthetic production multiples, using a $0.40/Mcf margin, as a function of R/P ratio and
discount rate. Present value increases as discount rate decreases, and the family of curves associated with a
particular multiple can be adjusted higher or lower by adjusting the discount rate. Figure 8 shows the effect
of discount rate on synthetic reserves multiple.

Figure 7—Synthetic gas production multiple with $0.40/Mcf margin as a function of R/P ratio and discount factor
SPE-201348-MS 9

Figure 8—Synthetic gas reserves multiple with $0.40/Mcf margin as a function of R/P ratio and discount factor

Synthetic Cash Flow Multiple

Plots of synthetic cash flow multiples were constructed, and exhibited a shape similar to the synthetic
production multiple. However, the ratio of PV/cash flow was identical for all margin values, making the
family of curves collapse to a single value. This occurs because as margin is adjusted, cash flow is impacted
linearly (both the numerator and denominator are affected proportionally). Consequently, a plot of synthetic
cash flow multiple as a function of R/P ratio and discount rate was constructed that is independent of the
margin assumption, and shown in Figure 9. Also, identical cash flow curves were generated for oil and for
gas, as the relationship holds regardless of the product modeled. As would be expected, cash flow with a low-
decline, high-R/P ratio forecast is more valuable than cash flow with a high-decline, low-R/P ratio forecast.

Figure 9—Synthetic cash flow multiple as a function of R/P ratio and discount factor
10 SPE-201348-MS

Exponential vs. Hyperbolic Decline

The synthetic production and reserves multiples for a margin of $1.50/Mcf for both exponential and
harmonic declines are shown in Figures 10 and 11. The results show that, over most R/P ratio values,
exponential decline profiles have a higher intrinsic value than hyperbolic decline profiles with the same
initial rate. This reflects the timing over which reserves get produced, with hyperbolic decline being much
steeper in the early years of a production profile, and then leveling off. The curves tend to converge and
then cross over at an R/P ratio value of approximately 20 years.

Figure 10—Synthetic production multiple as a function of R/P ratio and discount factor for exponential and hyperbolic profiles

Figure 11—Synthetic reserves multiple as a function of R/P ratio and discount factor for exponential and hyperbolic profiles.

Regression to Generate Equations

The curves plotted on the charts at the end of the paper can be closely approximated with regression analysis.
The shapes of the curves for different margins are similar, and can be scaled to a single curve for each
multiple. Production and Reserves multiples for oil and for gas can be calculated by multiplying three
factors: a factor for margin FM, a factor for the R/P ratio FR, and a factor for the discount rate FD,. The factor
SPE-201348-MS 11

for margin and R/P is discussed below for each multiple, and the factor for discount rate is discussed at
the end of this section. If the only value of discount rate used is 10%, then the factor for discount rate is
unity and can be ignored.

Production Multiple for Oil

The curve for a margin of twenty $/bbl was used for the regression analysis, and other margin curves were
scaled from this curve. A power fit (logarithmic on both axes) gave the lowest variance. The resulting
equation is:

where
C0= 1.307
C1= 0.870
C2= 0.00803
C3= −0.0459
C4= 0.00596

Production Multiple for Gas

The curve for a margin of one $/Mcf was used for the regression analysis, and other margin curves were
scaled from this curve. A power fit (logarithmic on both axes) gave the lowest variance. The resulting
equation is:

where
C0= 5.025
C1= 0.966
C2= −0.105

Reserve Multiple for Oil

The curve for a margin of twenty $/bbl was used for the regression analysis, and other margin curves were
scaled from this curve. A power fit (logarithmic on both axes) gave the lowest variance. The resulting
equation is:

where
C0= 2.297
C1= −0.0310
C2= −0.106
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Reserve Multiple for Gas

The curve for a margin of one $/Mcf was used for the regression analysis, and other margin curves were
scaled from this curve. A power fit (logarithmic on both axes) gave the lowest variance. The resulting
equation is:

where
C0= −0.875
C1= −0.0337
C2= −0.105

Cash Flow Multiple for Oil or Gas

As discussed earlier, the cash flow multiple curve is not a function of margin because the cash flow is
directly proportional to the margin. A logarithmic fit (logarithmic x-axis) gave the lowest variance. The
resulting equation is:

where

where
C0= 1.336
C1= 1.474
C2= 0.173

Factor for Discount Rate

The regression analysis utilized a discount rate of ten per cent (PV10) for the base case. Multiples get
adjusted higher (discount rate <10) or lower (discount rate >10) depending on the discount rate. The equation
for the factor for discount rate is:

where S is a slope on a logarithmic plot calculated as:

and:
< 10%
C0= -0.08817
C1= -0.02934
C2= -0.08313
C3= 0.007425
> 10%
C0= -0.11944
C1= -0.10581
C2= -0.03853
C3= 0.00818
SPE-201348-MS 13

Other Variables
The multiples analysis methodology can be improved significantly by incorporating margin as an additional
variable. However, there are still several shortcomings to the methodology.

Variable Margin
The margin for an asset may not be constant over time. A variety of factors, such as a contango or
backwardated commodity price forecasts, increasing or decreasing differentials, and changing operating
costs or gathering cost assumptions, can create scenarios in which margin is not constant. An increasing
or decreasing margin will impact the market value and the calculated multiple. Improved results may be
obtained by employing a margin that is volume averaged over the life of the economic run, with earlier
years being weighted more heavily, similar to a discount factor.

Product Mix
The economic runs used in this work are for either pure gas or pure oil. In reality, the value of most assets is
derived from a combination of gas, oil, and NGLs. Assuming a 6:1 conversion factor and current commodity
prices, a barrel of oil equivalent is more valuable than 6 Mcf of gas equivalent. To account for multiple
products, especially if the products are equally divided between liquids and gas, the multiples analysis
should be done for each pure product, and the total value calculated as the sum of the resulting valuations.

Reserves Mix
The economic runs used in this work are for existing production, which is Proved Developed Producing
(PDP) reserves. Generally speaking, PDP reserves are more valuable than Proved Developed Non-
Producing (PDNP) or Proved Undeveloped (PUD) reserves, because the non-PDP reserves are burdened by
the capital cost of establishing production or drilling and completing the well. PDNP and PUD reserves are
included in the total Proved reserves category that is the numerator of the R/P ratio. If the non-PDP reserves
have little or no value (as is the case of marginally economic drilling opportunities), the synthetic multiple
will be theoretically higher than actual market value, all other things being equal, because the synthetic
multiple assumes that the reserves are producing (100% PDP).

Upside
The economic runs used in this work are for existing production. If opportunities exist to economically
increase production and generate value, the associated multiple should be higher than for an asset without
such opportunities. These opportunities can be present in the form of workovers, recompletions, drilling of
new wells, reducing costs, optimizing commercial terms, etc. The production and cash flow multiples may
be understated (too low) if upside opportunities exist, because the opportunities have value not ascribed to
the production multiple.
PDNP, PUD, and other upside opportunities affect multiples calcualtions in other ways. The costs
associated with establishing production have an impact on margin and value. Also, for the purpose of
estimating market value, undeveloped reserves are usually discounted more heavily than PDP reserves.
Both of these considerations add further uncertainty to the multiples estimation process.

Conclusions
The equation for multiples, based on DCF economic runs, provide a valuation tool to show theoretical
market value, represented as multiples, as a function of R/P, margin, decline rate, and product.
The following conclusions were reached:
1. Multiples analysis is improved by considering not only the R/P ratio, but also the margin.
14 SPE-201348-MS

2. Equation for calculating multiples accurately reflect the multiples derived from economic runs. A
spreadsheet with the equations coded may be obtained by contacting rgajdica@gmail.com.
3. Synthetic multiples closely reflect the value and character of actual market multiples, especially for
assets with a high percentage of PDP reserves.
4. Cash flow multiple curves are independent of margin and product type.
5. For a given initial production rate, an exponential decline profile has greater intrinsic value than a
hyperbolic decline profile.
6. Variables other than R/P ratio and margin, such as variable margin, product mix, reserves mix, upside
and royalty, can have a significant effect on realized multiple.

Nomenclature
boe = barrel of oil equivalent
D= discounted rate (%)
DCF = discounted cash flow
FD = factor for discount rate
FM = factor for margin
FR = factor for reserves to production ratio
IP = initial production rate (Mcf/d or bbl/d)
LOS = lease operating statement
M= net margin ($/Mcf or $/bbl)
MCF = cash flow multiple (dimensionless)
MP = production multiple ($/Mcf/d or $/bbl/d)
MR = reserves multiple ($/Mcf or $/bbl/d)
Mcfe = thousand cubic feet of gas equivalent
NGL = natural gas liquid
PDP = Proved Developed Producing reserves
PDP = Proved Developed Producing reserves
PUD = Proved Undeveloped reserves
PV10 = present value using a 10% discount factor
R/P = reserves to production ratio (years)
SEC = Securities and Exchange Commission

SI Metric Conversion Factors

bbl × 1.589 873 E−01 = m3

Mcf × 2.831 658 E−02 = m3

References
1. Robert S. Thompson and John D. Wright (1985), Oil Property Evaluation (2nd ed.), Golden,
Colorado: Thompson-Wright Associates.