In all of the foregoing calculations it is assumed that the lease cost $10,000 and development $400,000, making the actual cash invested as $410,000 which is cost of oil. The depletion unit on this basis is $0.3026 per barrel. Each of the depletion units above is, therefore, decreased by this amount to show appreciated depletion rate by reason of the discovery clause. This is shown in the last column, and is tax free under the discovery clause of the law. In this example, 35 per cent of the oil or 527,871 barrels will be recovered after the first year. The depletion unit of $1.831 arrived at in the usual way will, according to regulations, maintain during the life of the well, 18 years. The expected price of oil can hardly exceed $2 based on five-year average, making the net expected price $2-$0.90 or $1.10 per barrel-yet the $1.831 depletion unit applies subject to limitation prescribed in the 1924 act. Thus it will be seen that the use of the market price of oil (without proper discount) at date of discovery, or 30 days thereafter, as a basis for valuation is questionable. It defeats the purpose for which the tax law was enacted-i. e., wipes out taxable profit. The average price of oil in 1920 for all grades was $3.06, while for 1921 it was $1.60 and in 1922, $1.61. Discovery is assumed to have been made as of December 31, 1920, and oil is assumed as selling at $3.06 the average for the year. Discovery value is set up on this basis as of January 1, 1921, and a depletion unit of $1.831 established. This then applied to the 1921 production (875,000X $1.831) gives $1,602,125 as a depletion deduction. The actual price received for the oil was $1.604 per barrel, from which must be deducted the 90 cents as cost of production, leaving a net income from oil sold of (875,000× $0.704) $616,000 which is approximately $1,000,000 less than the depletion allowance. Had depletion been allowed on cost of $0.3026 per barrel, the depletion deduction would have been (875,000X $0.3026) $264,775, leaving a taxable income ($616,000-$264,775) of $351,225. The cash receipts from the above hypothetical case, based on actual average price of oil for three years succeeding discovery and 89.83 per cent of total reserves, are shown in the following table: The present worth of the property, based on actual prices obtained for oil is $783,504, which includes $410,000 as cost of lease and development. This allows the purchaser 10 per cent compound interest on his investment, with no factor of safety beyond what this interest rate exceeds gilt edge securities. The value thus determined is only 32.8 per cent of that obtained by using the price of oil at its peak, viz, $3.06 per barrel. The depletion unit arrived at on actual selling price basis is 58.64 cents, of which 30.26 cents is applicable to actual cost (of lease and development), leaving 28.38 cents as the "appreciated depletion "by reason of discovery, as compared with $1.5284 when based on market price ($3.06) of oil on date of discovery. The actual result obtained emphasizes the need of carefully considering the future price of oil, as well as pointing out the fallacy of using (without modification) the posted price prevailing at date of discovery or within 30 days thereafter. The actual results show that a value determined by discounting the profits at a peak price (followed by a series of years at low prices) may, as in this case, be 300 per cent or more above what it should be. This well, whose value for discovery depletion is $2,481,037, had an earning capacity of only 10 per cent on the basis of $785,504, so that its market value as between a willing buyer and willing seller would not exceed $500,000. 92919-25-PT 11 -4 VALUE BASED ON 10-YEAR AVERAGE PRICE The 10-year average price at date of discovery was $1.35. At the end of the year the anticipated price could have been $1.40 (net 50 cents), and the price beyond that for the major portion of the remaining oil would have been approximately $1.50 (net 60 cents). The following table gives— VALUATIONS AT MARKET PRICE EQUAL SALES AT AVERAGE MARKET PRICE A series of valuations of this hypothetical property as of January 1, each year from 1916 to 1922, inclusive, based on the average price of oil as of the preceeding year, gives aggregate valuations of $7,479,559 (seven valuations), as compared with sales of production of $8,034,730 (receipts discounted at the same rate, 10 per cent), giving a margin of only 7.4 per cent as between the discovery value and of total income. A margin entirely too narrow to be considered a safe investment. During the five years 1916-1920 there is a margin of 58.8 per cent in favor of the Government for taxation purposes; but during the last two years (1921-22) of declining prices, this is practically wiped out with an operating loss of 51.8 per cent. While the margin of profit is apparently greater when using the three-year and five-year average prices, yet it must not be overlooked that in using these long-period averages it will be three years and five years, respectively, before the influence of the peak price of 1920 is eliminated. Using the three-year average price as a basis, discoveries could be allowed for 1923 at $1.524 per barrel, while the market price is only $1.34; using the five-year price average the discovery valuations in 1923 would be based on $2.06 oil when the market is $1.34, which, of course, does not set up the correct value as between a willing seller and a willing buyer. It will be noted that the valuations are more erratic when the market price is used as a basis. The three or five year bases show more uniformity, but in the long run the result will be approximately the same as when market price is used. The average of a large number of valuations over a long series of years at market price will equal the actual receipts at market price during a long series of years. This, of course, assumes that the actual production equals estimated reserves. Carrying these valuations back another seven years, making 14 valuations in all (one for each January 1), gives the following result: Aggregate of 14 valuations__. Aggregate of sales from same_ Per cent, margin of safety over a period of 14 years__ $10, 264, 606 10, 597, 254 332, 548 3. 24 This shows, as set forth elsewhere in this report, that in the long run, when many valuations are considered at actual market price over a period of years, the discovery values approach the value of actual sales, leaving no margin of profit for a prospective purchaser and no taxable income for the Government. Valuations based on a rising market will result in a taxable gain only so long as the price continues to rise. When the market enters a declining-price period the depletion established during the rising market will extend to and be applicable in the years of declining prices, thus wiping out any taxable gain. Valuations made on a declining market result in no taxable gain, inasmuch as the market price is less than the discovery price. Taxable income will accrue only during rising prices. Deficits will accrue (by reason of depletion) during declining prices, and in the long run will offset the other. In view of these conditions it is apparent that the discount rates and production hazards should be scrutinized. The application of a 10 per cent compound discount to determine present worth is not sufficient unless a liberal hazard factor has been applied previously. Even then it is questionable whether 10 per cent is enough. Wells at the best are short-lived, usually 60 per cent of the ultimate oil being recovered during the first year. The total invested capital should be returned within three to five years, which means a dividend on capital of 20 to 33 per cent per year, to say nothing of interest (profit), on the investment in a hazardous industry. EARNING CAPACITY-INVESTMENT HAZARDS The accompanying tables, 5 and 7, show the earning capacity of a lease wherein different discount factors have been applied to the estimated value of reserves when the market price of oil is $3.06 or a net price of $2.16 after 90 cents has been allowed for pumping and production costs. The discount rates range from 5 per cent, which has been applied in some instances, to 25 per cent, which to my knowledge has never been applied. The discount rate often used by the oil and gas section is 10 per cent applied to the middle of the year. The present worth column in this table represents the net proceeds of the oil which in each case of necessity includes the drilling and equipment of wells required to produce the oil. On the lease in question this is estimated at $400,000 to cover the drilling of 20 wells. This amount, plus $10,000 (cost of lease) would represent therefore, the actual cost of the oil reserves, or $0.3026 per barrel. Deducting this amount from present worth represents amount of depletion resulting by reason of the discovery clause. About 1 This does not represent annual earnings but the total earning over the 19-year life of property 65 per cent of total income will be received at end of first year, 17.9 per cent second year, 7 per cent third year, and 10 per cent during the remaining 16 years. The present worth includes $400,000 estimated cost of 20 wells. Assuming that the oil reserves are definitely known and that no additional dry holes will be drilled on the lease, there remain certain hazards in the industry for which adequate provision must be made in order that a prospective purchaser shall be able to receive on this investment an ample return to justify the expenditure of large sums of money. This same money may be invested in real estate mortgages which yield a net annual return of 5 to 7 per cent. Railroad bonds and utility corporation bonds are considered safe and sound investments yielding 5 to 7 per cent. What then should an investment in hazardous oil ventures yield in order that the investor may be amply repaid for the risks involved? What discount rate should be applied to obtain the present worth of an oil valuation based upon the posted market price of oil? If the reserves are definitely known, the following hazards are of such importance that they must be given due consideration before making an investment: 1. The uncertainty of the price of oil. A drop of 10 per cent may wipe out all possible profits on the basis of a 5 per cent discount rate. 2. Losses by fire, wind, etc. A single 55,000 barrel tank may be the only margin between a profit or a loss on the investment. 3. The encroachment of salt water. anticipated profit into an actual loss. The loss of a single well may turn 4. Loss of casing by reason of corrosion. loss of a well. This may mean the possible total This has a decided affect upon the or investor is not financially able 5. Drainage into neighboring offset wells. total reserves, especially when the operator to drill wells sufficiently fast to keep pace with the drilling program of his neighbor. 6. Local taxes. 7. Leakage in storage and transportation. The following table shows the result of applying some of these losses: TABLE 8 Losses which may occur in the operation of any lease |