Valuation of Producing Properties for Loan Purposes

There are several methods of valuing producing properties and numerousconcepts of value, and they all have their purpose. From the standpoint of thelender on oil properties, the primary objective is to judge what might berealized from the sale of the property if it should become necessary toforeclose. For this purpose, the most significant concept of value is the "fairmarket value" - the price at which the property would be sold by a willingseller to a willing buyer, neither being under any compulsion to buy or tosell, and both being competent and having reasonable knowledge of thefacts. The method of valuation generally used by the institution with which theauthors are associated is the estimation of the present worth of future profitsat that discount rate which it is believed will result in the fair marketvalue. This is often termed the engineering or analytic appraisal method andfor several reasons is found most useful in valuing properties submitted ascollateral for loan purposes. Most important is to ascertain by our ownappraisal that the amount of the loan outstanding at any time could berecovered, if necessary, by foreclosure and sale. Another important factor injudging the goodness of a loan is the ability of the property to generatesufficient net cash income, after all necessary operating, development, andincome tax requirements, to amortize the loan within a reasonable time. This isascertained from a payout schedule which is readily derived by a cut-and-tryprocess from the forecast of net profits used in calculating the value, asshown in Tables IV and V. In addition, when the purchase of a property ispartially financed by a loan, the lender and the buyer are in effect acquiringthe property jointly. Prudent lenders will avoid participating in a projectwhere the expenses may become so high that the operator might be unable to meethis obligations. And good bankers should avoid being a party to a transactionat a price so high that the customer later finds he has made an unprofitable purchase.