SPE 8194

SPE
Society of Petroleum Engineers of AIME

CRUDE OIL PRICING REGULATION- CONSIDERATIONS FOR THE

EVALUATION OF U.S. PETROLEUM COMPANY ACQUISITION CANDIDATES

by Philip C. Crouse, Member SPE-AIME, Sun Production Co.;

and Michael L. Neely, Champlin Petrnleum Co.

©Copyright 1979, American Institute of Mining, Metallurgical, and Petroleum Engineers, Inc.

This paper was presented at the 54th Annual Fall Technical Conference and Exhibition of the Society of p t 1 E · t AIME h ld · L
author. Permission to copy is restricted to an abstract of not more than 300 words. Write 6200 N. Cen~~~E~up~.• ~~~~::~~~xas 2o~. rn as Vegas, Nevada, September 23-26, 1979. The material is subject to correction by the
75

Introduction On June 27, 197 4, the Federal Energy Administra-

tion (FEA) was formed; and at this time it was
The Federal energy regulations pertaining to the becoming evident that Federal price cont;ols were
first sale of domestic crude oil have significant not temporary constraints: Two further bills
impact in determining the proper monetary value to affecting and amending the EPAA were passed and
assign a U.S. petroleum company acquisition can- signed into law. These bills further .complicated
didate. Domestic crude oil pricing regulations ori- crude oil pricing. On March 1, 1977, the FEA was
ginated from the economic programs implementing the reorganized and incorporated into the Department of
Economic Stabilization Act of 1970 and have remained Energy (DOE), a 10 billion dollar-plus agency
throughout the last nine years as complex, costly designed to address and solve the energy problems in
and burdensome regulations. Because of the current the United States.
structure of crude oil regulations, an acquisition
task force must spend a significant amount of time Current Pricing Developments
and effort in determining the proper regulatory
classifications of crude oil along with pricing pro- All authority to control the price of domesti-
jections to incorporate in the evaluation of an
cally-produced crude oil expires on September 30,
acquisition candidate's crude oil producing 1981 under the Energy Policy and Conservation Act
properties. (EPCA) of 1975, which amended EPAA. Effective June
This paper summarizes current pr1c1ng 1, 1979, the pricing of domestic crude oil became
mechanisms, a suggested internal crude oil regula- discretionary with the President. On April 5, 1979,
tory group interface with an acquisition task force, as part of a major energy address to the nation the
and provides illustrations of forecasting pricing President announced that he had adopted the p~licy
conditions ranging from a status quo continuation of of phased decontrol with a proposed windfall profits
the crude oil regulations to full price decontrol tax, which must be passed by Congress before
for crude oil. A theoretical crude oil property is becoming law. If the windfall profits tax is
u~ed to demonstrate a workable, time-reducing tech-
adopted by Congress as the President has recomm-
nlque of regulatory group evaluation for an acquisi- ended, full decontrol at the wellhead would occur on
tion task force. Case economics are also shown October 1, 1981. The upper tier tax would phase out
depicting purchase price and present worth impacts on January 1, 1991; but the market incentive tax
of different resolutions of a forecast of prices would be permanent.
wi~h sensitivities of potential regulatory impact~ The President's Phased Decontrol Schedule
be1ng recommended for presentation to management.

Advent and History 1. As of June 1, 1979, newly discovered oil is per-

mitted to receive free market price.
Domestic crude oil pr1c1ng regulations orlgl- Regulations were promulgated by the Economic
nated from the Economic Stabilization Act of 1970. Regulatory Administration (ERA) of the Depart-
This Act was administered in four phases with its ment of Energy on May 2, 1979 (44 FR25829).
statutory authority set to expire on April 30, 1974.
During Phase IV implementation, the 1973 Arab Oil 2. Effective June 1, 1979, the Department of Energy
Embargo occurred. Rapidly escalating foreign crude also promulgated a rule under which certain pro-
prices and the passage of the Emergency Petroleum duction from marginal properties may be sold at
Allocation Act (EPAA) of 1973 helped to promote fur- an upper tier price (April 22, 1979, 44
ther regulations on crude oil. FR25160). The rule defines marginal properties
as those properties which produced below a
References and illustrations at end of paper.
 CRUDE OIL PRICING REGULATION - CONSIDERATIONS FOR THE
2 EVALUATION OF U.S. PETROLEUM COMPANY ACQUISITION CANDIDATES
certain volume of crude oil per well per day
depending upon the average completion depth of
all crude oil producing wells on such
properties. The base production control level,
against which current production volumes are
measured to determine upper tier volumes each
month for marginal properties, is set at 20 per-
cent of the average monthly production and sale
of lower tier crude oil.from marginal properties
for the period of June 1, 1979 to December 31,
1979. The schedule of average well depth and
average daily production volumes used to deter-
mine a marginal property are:
Under 20 barrels/day (3.18m 3/day) between
2,000 (609.6m) and 4,000 feet (1219.2m)
Under 25 barrels/ day ( 3. 97m 3I day) between
4,000 (1219.2m) and 6,000 feet (1828.8m)
Under 30 barrels/ day ( 4. 77m 3 I day) between
6,DOO (1828.8m) and 8,000 feet (2438.4m)
Under 35 barrels/day (5.56m 3 /day) below
8,000 feet (2438.4m)
On January 1, 1980, the base production control
level for marginal properties will be reduced to
zero and all current production will be eligible
for the upper tier price.
3. Beginning on January 1, 1980, producers who
invest in enhanced recovery projects after January
1 , 1980 may release specified volumes of lower tier
oil to upper tier category in order to receive
"front-end money" to help finance that
investment. No final rule has been promulgated
at the time this paper was prepared.
4. Beginning on January 1, 1980, the upper tier oil
price will increase in equal monthly increments
until it reaches free-market price on October 1,
1981. At the time of this writing, the ERA has
not issued a proposed rulemaking.
5. The Department of Energy has also promulgated a
rule in which the base production control levels
for all properties other than marginal
properties will be permitted to decline at a
rate of 1-1/2 percent per month from January 1,
1979 through December 31, 1979 (April 22, 1979,
44 FR25160). Between January 1, 1980 and
October 1, 1981, the decline rate will equal 3
percent per month.
Pricing Mechanisms
1. Property- the right which arises from a lease
agreement or from a fee interest to produce
domestic crude oil. Lease agreements may deter-
mine this right by surface boundaries, depth in-
tervals, underground strata, royalty interests,
or other parameters. Property is the entity
used to determine the appropriate classifica-
tion (e.g. "old" oil) of domestically produced
crude oil and hence the correct price.
2. Base Production Control Level (BPCL) a collected by the first purchaser of the crude
historic volume of crude oil produced and sold
from a given property above which a producer
must increase production levels in order for
some of the production to qualify as "new" or
"upper tier" crude oil (See Figure 1), BPCL's
SPE 8194
are generally adjusted by a BPCL adjustment
factor defined in the regulations.
3. Current Cumulative Deficiency (CCD) - the nega-
tive algebraic sum of the volumes by which
monthly sales of crude oil from a property have
been less than or greater than the monthly BPCL
for that property. The deficit does not
accumulate until new oil has been sold from the
property. A deficiency must be offset by an
equivalent volume of otherwise new oil which
must be sold at old oil prices.
4. Old Oil - generally total crude oil sold in a
given month less any created new crude oil.
5. New Crude Oil - total crude oil sold in a given
month less the BPCL and CCD.
6. Stripper Well Property - any property whose
average daily production of crude oil (excluding
non-associated condensat~ per well did not
exceed ten barrels (1.59m ) per day during any
preceding consecutive 12 month period after
December 31, 1972. Crude oil from a stripper
well property may be sold at free-market
clearing prices.
7. Marginal Properties- as of June 1, 1979, a pro-
perty which meets the qualifying thresholds out-
lined for marginal properties in the
"President's Phased Decontrol Schedule" section
above. From June 1, 1979 to December 31, 1979,
a qualified marginal property has a daily BPCL
set at 20 percent of the property's 1978 old oil
sales divided by 365 days. All oil produced
above this BPCL receives upper tier prices.
After December 31 , 1979, all oil sold from a
qualified marginal property is to be priced at
upper tier prices.
8. Newly Discovered Crude Oil - crude oil produced
from an Outer Continental Shelf (OCS) lease
which was entered into on or after January 1,
1979, in an area from which there was no produc-
tion in calendar year 1978; or crude oil
produced from a non-OCS property from which no
crude oil was produced in calendar year 1978.
Areas of Uncertainty for Valuation
1. Windfall Profits Tax- the largest variable and
risk in valuation of an acquisition candidate is
the type of tax which may be imposed by
Congress. Any tax is a mechanism to reduce
crude oil revenues received by the producer.
On April 26, 1979, President Carter
presented to Congress the Administration's pro-
posals for a "windfall profits" tax. The
proposed tax on profits is actually a permanent
excise tax and would become effective January 1,
1980. The tax would be · applied to revenues
resulting from future OPEC price increases and
the decontrol of current upper and lower tier
oil. The tax is to be paid by the producer and
oil, who in turn will remit the tax revenues to
the U.S. Treasury on a semi-monthly basis.
Because the tax is an excise tax, it will be
deductible for Federal income tax purposes.
SPE 8194 PHILIP C. CROUSE AND MICHAEL L. NEELY
The Administration's proposal would
establish an excise tax rate at 50 percent. In
addition, a tax would be levied on the
difference between the price at which each
taxable barrel of crude oil is sold and its base
price, multiplied by the volume of the oil sub-
ject to the tax.
Table illustrates that there would be
three base price tiers for purposes of computing
the tax under the Administration' s proposal.
Tier 1 would be the current lower tier, or old
oil, ceiling price adjusted for inflation. Tier
2 would be the current upper tier, or new oil,
ceiling price adjusted for inflation. Tier 3
would be the "market incentive price", or the
proposed 16 dollars per barrel adjusted for
inflation and quality differentials.
2. Expanded Definition of Stripper Well - certain
proposals before Congress would change the DOE's
currently issued marginal property regulations.
Legislation offered would allow free-market
clearing prices versus upper tier prices and
would allow injection wells to be counted when
determining average daily production per well.
In addition certain legislation has proposed
that "high water cut" crude oil also be released
to free market prices.
3. Tertiary Enhanced Recovery Pricing - the DOE's
present regulations permit incremental tertiary
crude oil production to be sold at free-market
prices. Bills have been introduced which would
release all crude oil produced and sold from a
qualifying tertiary enhanced recovery project
from price controls.
4. Status Quo (pre-June 1, 1979) Continuation -
legislation has been proposed which would con-
tinue price controls on domestically produced
crude oil. Because of this possibility a firm
should look at the maximum downside risks of
pricing crude oil.
Crude Regulation Interface with Acquisition Task
Force
When analyzing an acquisition candidate's pro-
perties, the most current pricing information avail-
able on crude oil properties generally provides the
best means to project future prices which the
property will receive. For operated properties, the
crude regulatory group should review all records
available pertaining to a property's BPCL, BPCL
adjustments, CCD, stripper property qualifications,
marginal property qualifications and newly
discovered oil qualifications. For those properties
which are opera ted by others or for which current
price data is not available, profit/loss statements,
production records and other material which may be
available could be used as resource material in
establishing a starting point for projecting future
prices. Whatever information is utilized, the
acquisition task force must arrive at some
reasonable estimate of the proper regulatory classi-
fication to be assigned each property. This task
must be accomplished with a high degree of reliance,
for any inaccuracies could result in materially dis-
torted economics.
Example Property - Regulatory Historical Review
3
When reviewing an acquisition candidate's crude
oil properties, any task force is faced with the
uncertainty of pricing variables which could signi-
ficantly distort the economics of such a study.
Some form of regulatory "audit" must be per-
formed in order to assure management that the
pricing assumptions used in the study are reasonable
and future regulatory compliance actions will not go
undetected, either for historical or current
periods.
For instance, use as an example a property for
which information on the following pricing variables
has been provided by the acquisition company and
used by the task force in projecting prices:
(A) BPCL = 600 barrels/month (95.39M 3 /month)
(B) CCD = 1200 barrels (190.79M 3 )
(C) BPCL decline factor = 15 percent
Before any reliance can be placed on these
variables, the task force must use some means to
verify its reasonableness. In this instance the
means would consist of production records since
sales information is usually not provided for prior
periods.
If production records are used, the crude
regulatory group would first have to establish an
error tolerance level because the regulations
generally base category determinations on sales.
Once this has been accomplished, production
information for every month from January 1, 1972
through present would be gathered and then used to
recalculate a BPCL, CCD and BPCL decline factor.
For this property let's assume that the
recalculated pr1c1ng variables using production
data are as follows:
(A) BPCL = 580 barrels/month (92.21M 3/month)
(B) CCD = 2700 barrels (429.27M 3 )
(C) BPCL decline factor = 14 percent
Using the ten percent error tolerance level any
recalculated pricing data which falls within the
following ranges can be accepted:
(A) BPCL - 540-660 barrels/month (85.85-
104.93Mj/month)
(B) CCD = 1080-1320 barrels (171.71-209.86M 3 )
(C) BPCL decline factor = 13.5-16.5 percent
As can be seen, the data provided by the
prospective company for the BPCL and BPCL decline
factor appears reasonable and reliable. However,
information provided on the CCD falls well outside
tolerance levels and therefore this number cannot be
relied upon. Since all other variables appear
reasonab3e, it can be assumed that the 1200 barrel
(190.78M) CCD provided by the acquisition company
is not accurate and the recalculated CCD of 2700
barrels (429.27M3 ) should replace it. Thus, if the
data provided by the acquisition company had not
been "audited", the task force's pricing projections
would have been overstated by 1500 barrels
 CRUDE OIL PRICING REGULATION - CONSIDERATIONS FOR THE
4 EVALUATION OF U.S. PETROLEUM COMPANY ACQUISITION CANDIDATES
( 238. 48M 3 ) of new crude oil and the acquisition
economics would not be representative.
Stripper properties provide a somewhat
different pricing position to verify. Although qua-
lification for the "stripper well" lease exemption
is based on production, it also is based on the
property's number of actual producing days. Produc-
tion data generally is readily available, however,
actual producing days must be extracted from some
other source if available, or if not available then
maximum producing days must be used. Management
should be aware that an overstatement of value may
occur with this assumption. Once data on these two
variables has been gathered, the task force can
begin to calculate average daily production per well
(ADPW) on rolling twelve month periods beginning
after December 31, 1972. If durin§ any period the
ADPW falls below 10 barrels (1.59M) per day then
the task force can assume the stripper classifica-
tion is valid If the ADPW never falls below 10
barrels (1.59M3) per day then the stripper classifi-
cation can be deemed to be incorrect and the
property priced in accordance with the two-tier
pricing mechanism. The stripper property review is
important when considering that "stripper well"
crude oil is exempt from regulations and sold at
market clearing levels. To improperly classify a
property as "stripper" could result in a significant
distortion of acquisition economics.
Assuring that pricing variables are reasonable
entails a great amount of additional work for a
crude oil regulatory group. However, considering
that crude oil prices range from a low of 6 dollars
per barrel to approximately 20 dollars per barrel,
the implications are all but too visible. To over-
state prices could result in tendering an offer that
is well above the actual economic worth of the
company, while to understate prices could very
easily result in not achieving the task force's goal
of acquiring the company.
Case Property for Acquisition Evaluation
Assume a company has announced intentions to
sell a property on which crude oil was discovered in
1971. Production is declining and estima~ed
remaining reserves are 214,247 barrels (34,065m ).
Sixteen years are remaining to fully produce the
reserves. Production is from 1900 feet ( 579. 1m).
No additional development plans are anticipated for
the property.
Evaluation Assumptions
1. The time rating of production is exhibited in
Figure 2.
2. Department of Energy prices as of January 1979
are used as initial base prices. Stripper or
free-market prices use an assumed base of $18.75
per barrel. Prices are escalated at six, seven,
and eight percent for each category. Also,
special cases use President Carter's decontrol
program and assume no tax. In addition, one
case looks at a one dollar base price increase
in free market prices. Table 2 exhibits. the
price cases viewed.
3. Effective tax rat~ on the property is
percent.
SPE 8194
4. Royalty is 1/6th of 6/6ths.
5. Tax life is 11 years.
6. Discounting is annual end-of-period.
7. Purchase price is 30 percent depreciable.
8. A January 1, 1979 purchase date is assumed.
9. Operating costs excluding depreciation and
depletion escalate at approximately 8 percent.
It was assumed that no variance occurs from
higher prices (ad valorem and severance taxes
would increase as higher prices are realized).
10. Economics assume that no additional reserves are
added which may result from extending an
economic limit or development drilling. This
assumption allows _analysis of price variance
only (that is, the change in price times a base
volume).
Results
Figures 3 through 6 exhibit after-tax cash flow
present worth versus discount rate. Figure 3
exhibits price category sensitivities at an 8
percent yearly price increase. If pre-June 1, 1979
pricing is reimposed by Congress, the present worth
of lower tier and upper tier properties will be
significantly suppressed when compared to the free
market cases. Undiscounted after-tax cash flow
ranges from 632 thousand dollars to 2999 thousand
dollars. Figure 4 shows lower tier sensitivities.
Changes in price escalation rates are of minor risk
when compared to the effect of the Carter decontrol-
no tax case; undiscounted cumulative after-tax cash
flow quadruples and provides significantly higher
economic incentive and higher present worth.
Figures 5 and 6 show upper tier and free market
sensi ti vi ties. With less change of large price
increa~es available, the sensitivity in pricing is
less than the sensitivities portrayed in Figures 3
and 4.
Purchase price is the bottom line of an
acquisition. Sensitivities of purchase prices were
performed for a 10 percent and 15 percent after tax
rate of return. Table 3 shows that if the example
property is classified as lower tier, a percent
change in price escalation adds a variance of
approximately 9 percent. A Carter decontrol-no tax
case adds a 325 percent variance over a status quo 6
percent price growth case. For upper tier
classifications, there is a 54 percent variance
between a 6 percent price growth and a Carter
decontrol-no tax case. Table 4 shows the purchase
price per barrel of purchased reserves. Under a
Carter decontrol-S percent price escalation-no tax
case, reserves purchased for $5. 25 per barrel at
lower tier and $6.15 per barrel at upper tier would
yield a 15 percent after tax rate of return.
Conclusions
1. Price forecasting assumptions and price
category determinations significantly impact
the valuation problem for determining a fair
purchase price for an acquisition candidate.
50
SPE 8194 PHILIP C. CROUSE AND MICHAEL L, NEELY 5

2. Pricing is one of the prime sensi ti vi ties an upside, and expected value cases for presenta-
acquiring firm must consider. tion to management.

3. Once a category is established for a property, 4. Lower tier properties have the most valuation
the acquisition team should look at downside, risks in the current environment.

TABLE 1
ADMINISTRATION PROPOSED WINDFALL PROFITS TAX CATEGORIES

VOLUME SUBJECT TO PRICE DIFFERENTIAL SUBJECT

TAX CATEGORY DECONTROL PRICE MECHANISM _ __c:_W.::ciNc:.::DFALL TAX TO WINDFALL TAX

LOWER TIER OIL Lower tier oil phased out through
(Tier 1) reduction in base production
control level ( BPCL); BPCL reduced
1-1/2% per month from January 1,
1979 thru December 31 , 1979 and
3% per month from January 1, 1980
thru September 30, 1981. RemaindJr
is decontrolled effective October
1' 1981
1 . Lower tier oil in excess of
a 2% BPCL decline, which
was freed to upper tier price.
2 .· Lower tier oil freed to the
upper tier price in excess
of the amount released if the
BPCL was reduced by 2% per
month commencing January 1, 1980
1. Difference between the sales
price as the upper tier price
is decontrolled and the
upper tier base price
2. Difference between the sales
price as the upper tier price
is decontrolled and the lower
tier price (or lower tier base
price after September 30, 1981)

3. Lower tier oil at or below 3. None

declining BPCL is not subject
to windfall tax.

UPPER TIER OIL On January 1, 1980 upper tier
(Tier 2) ceiling price will increase in
equal monthly increments to
free-market price by
October 1 , 1981
Upper tier oil except oil other- Difference between the sales
wise subject to tax at lower price as the upper tier price
tier level is decontrolled and the
upper tier base. price

UNCONTROLLED CRUDE OIL "Uncontrolled" Oil not otherwise subject to tax Difference between free-market price
(Tier 3) as lower tier or upper tier taxable and market incentive tier base
volume, excluding ANS oil and price
Federal royal ties

MARGINAL PRODUCTION
Upper tier price for sales in Marginal production subsequent Difference between the sales
excess of 20% of BPCL to January 1, 1980 is included price as the upper tier price
determined using 1978 lower in the upper tier volume is decontrolled and the
tier oil effective June 1, 1979 upper tier base price
thru December 31, 1979; upper
tier price for all sales beginning
January 1, 1980

ENHANCED RECOVERY PROJECTS
Lower Tier Oil Released
to Upper Tier
Specified volumes of lower tier
oil released to the upper tier
price to finance investment in
enhanced recovery projects
commencing January 1, 1980
Sales at upper tier prices Difference between the sales price
included in upper tier volume as the upper tier price is decon-
trolled and the upper tier
base price

TABLE 2
CASE PRICES

Lower Tier · Upper Tier Free Market Carter Decontrol-No Tax

Lower Tier ~er Tier
~ 1.! .!!! ~ 1.! .!!! ~ 1.! .!!! Base+$1

1979 5.92 5.95 5.98 13.04 13.10 13.17 18.75 18.75 18.75 19.75 6.60 13.17
1980 6.28 6.37 6.46 13.82 14.02 14.22 19.88 20.06 20.25 21.33 10.05 16.05
1981 6.65 6.81 6.98 14.65 15.00 15.36 21.07 21.47 21.87 23.04 17.60 20.65
1982 7.05 7.29 7.53 15.53 16.05 16.59 22.33 22.97 23.62 24.88 23.62 23.62
1983 7.47 7.80 8.14 16.46 17.17 17.92 23.67 24.58 25.51 26.87 25.51 25.51
1984 7.92 8.34 8. 79 17.45 18.37 19.35 25.09 26.30 27.55 29.02 27.55 27.55
1985 8.40 8.93 9.49 18.50 19.66 20.90 25.60 28. 14 29.75 31.34 29.75 29.75
1986 8.90 9.55 10.25 19.61 21.04 22.57 28.19 30.11 32.13 33.45 32.13 32.13
1987 9. 44 10.22 11.07 20.78 22.51 24.38 29.88 32.22 34.70 36.56 37.48 37.48
1988 10.02 10.94 11.95 22.03 24.08 26.33 31.68 34.47 37.48 39.48 37.48 37.48
1989 10.60 11.70 12.91 23.35 25.77 28.43 33.48 36.88 40.48 42.64 40.48 40.48
1990 11.24 12.52 13.94 24.75 27.57 30.71 35.59 39.47 43.72 46.05 43.72 43.72
1991 11.91 13.40 15.06 26.24 29.50 33.16 37.73 42.23 47.22 49.73 47.22 47.22
1992 12.63 14.34 16.26 27.81 31.57 35.82 39.99 45.18 50.99 53.71 50.99 50.99
1993 13.38 15.34 17.56 29.48 33.78 38.68 42.39 48.35 55.07 58.01 55.07 55.07
1994 14.20 16.42 18.97 31.25 36.14 41.78 44.94 51.73 59.48 62.65 59.48 59.48
 TABLE 3
PURCHASE PRICE SENSITIVITIES

CASE 10% ROR AFIT 15% ROR AFIT

__!it_ __!it_
Lower Tier
6% 367 265
7% 403 287
8% 440 311
Carter 1652 1125

Upper Tier
6% 1180 857
7% 1257 905
8% 1341 958
Carter 1876 1318

Free Market
6% 1832 1332
7% 1932 1394
8% 2039 1460
8% + $1.00 2164 1507

TABLE 4
PURCHASE PRICE SENSIVITIES

Purchase Price
$/BBL
Case 10% ROR AFIT 15% ROR AFIT
Lower Tier
6% 1. 71 1. 24
7% 1.88 1. 34
8% 2.06 1.45
Upper Tier
6% 5.51 4.00
7% 5.87 4.23
8% 6.26 4.47
Free Market
6% 8.55 6.22
7% 9.02 6.51
8% 9.52 6.82
Carter Decontrol Case-No Tax
Lower Tier 7.71 5.25
Upper Tier 8.75 6.15
Free Market
8% + $1 Base 10.10 7.03

CJ OLD CRUDE 01 L

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DISCOUNT RATE %
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