PetroleumProductionFinancing - A Further Look

By Alan Smith and R. W. $chattke

It is &doubtedly true-thatcertain benefi%s can be derived’from exter-

nal financing of petroleumproduction. Mr. A. J. Pearson, in an article

appearingin the March, 1963,issue of the Journal, discussedthe various

.,
types of financingavailableand the advantagesof each type.l Using

present value computations,he determinedthe relativeadvantageof each

type of loan. It is our contentionthat Mr. PeXsonis economicanalysis

overstatedthe benefits to be obtainedby external financing,and-that such

benefits,while substantial,will usually be limited to”tax advantages. As

a startingpoint, we can examine three tables from this previousarticle.

OF FROWRT, vi”
1.r.,,~.rwr,w$[ CASH (P”RC”ASE PRICE ‘- WIO,OCU CASHI
,!. , 1 Tb> I766 1’?65. ! 966 ~o.?.ii~: 101.
---- ---- ---
c-r!..
Iu,--- $! cm (lgn
J (J.onn
$ I f31J COO SI;LJ.:WI$ $Im,rd)o 5KI0,134W $1.0:;
i ;,: :..
$
t mm,, ,.,. 10.004 loom 50,0G0
I%p, v “., ,...., v.rwo q.000 ‘4:000 V,ooo .4S,0fitj S:;
Not 1,+,.,.n. nl, mm 81,000 als)co 814900 .465.000 6 .. . . :
Iwo,.. is.. - . 26,520 26,520 i.5,520 26, >20 132,603 2t5.. .’.
Co\h.l,, , ,. 4:! $!
Cmih rh 63,411: 63,4B: 63,4B: 63,48: 3 I ?,40: 234..,:
P,”! V.e !1.
(4 l-l +%. ( ,..?[ s 33?,592 $ 54,60; $ M.457 $44,753 S40.4’?4 $151,493 $ 1.?1;
BE,,,,.,, .,. ... Iuw. o,,,, nfir, g expensm, faw,head and ad wdorem tax,

500/. N.* Inca-n $40,500,

~~!,,.~ (-,,.!, I.’om$ $27, sor
h Ahcmwhle D,V)IPIK. $Jc.000
To. ROIO it4et lmomm AIIo*cIMo Dtplellanl = 0.52 {$81,000 - $30,000) ‘“$26,S70
ffcp.i.cint;om N+! la, orn.. l.come Tax -- Cash Povment.

1
A. J: Pearson, “Scme.Guidesto Proper Loan Selectionin Petroleum
Financing,~lJournai
—— of —
petroleumTechnolcw?,(March,1%3), PP. ZR-ZX5*
 -2-

.—
lAiME&PU2CHA!.L G P.KWRIY wITH PRODUCTION LOAN
[PURCHASE PRICE =’$41w),uO0 = $tOO,OW CASH + $300,000 IOANI
1,.. T l%? !963 1%4 1965 4Qb6 4kimain, lot~.”
-.,.
GIQSS l.ce”w- $:00:000 $100.000 5100000 $Wooo $Imoo - sl.oi&
FxPcn,e* 10,100I 0,0( C I 0,000 10,000 10,OOO
{“I*,,? t 14.975 11,201 7,310 3,221 } 38 ‘o 30:7;!
Qc,xt
...
S2epre<i.l: on’ ! v, 000 9.0.30 9,000 9.000 9,000 45,000
Net IMOIW2 .54,125 *9.799 73,680 77,779 80,862 405,000 773,:,’
Illconle.’ToK. “ * 18,785 ?0,6’?5 22,7.1A 24.845 !46,448 132,600 ZA.$.ct’
Cmh Pu>nmn, 100,000 0 0 0 0 10C,3Y
Pavilwnt to 100. 45,125 68,70t 72,680 76,779 16,617 . ~(j,(.?
Cm,h ~!C.W. !oa.7a5 --10,695 .- 12,7!4 -14,a4s 46,7*7 317,40: 217.1M
Pm< We,, h
@ 10 Per Cent s 108.360 S-- Q,2O9 $-. Q.9O5 $–.fO,46b $ 2Q.FJ52 $1$1,4?5 $ 43.’;”
●E.pb.n.e qpereting eKpenww, ovorheod nnd od valorem tax.
i..ludct
., EU,,;,Y ~,,,t bv diw:ded bcfwen” Fq”t”r.e. t A<co”nt IC, be depredated and Leowh.ald Account 10 be d*rJ@l~
AWJmC SIO!), OO<)to Equipment kccount ond $300,000 to Leomtiold Account.
1962 Gtos$ [ricome
sc Ourw. c”a!+. foI IV~2 TOiii-arb$Iim~~m~ IEIIUIP. ACCt. - SOIV0901 ‘~~wW~:< SVO.WO *v,oX
,,
I%orr.<ioI,
o, I c.*11,1,Ii. o bscalcwlaled !,v <cvmoi olher methods
$
!9$2 Gr.a,’ I“<c.m*
.,. Fo, I $4,> (r,. , oeplmion : - -------- .—fl@o.r.hold Accl. ) =-#’#~ X $300,000 = $30.~
TO~,al Gr05f Income ,.

$j./6 tI... $33, F162,~

..*IIIO
??,., % (-..” , (“<cwe $27,$00,
;;cc~;,;~;;;)” D“’pt’on S30,000.
RcIle [t401 lnctk,e - Aliowoble Deplmlon) = 0,52 1S66,12S - s30,000] = $1a076$
Cmh i%w G.,., ec,”lk. : kl$lnrom. — Iniomu TaK — Cash Payment - Poynmnt 10 LOWI.
i
~!
(

(?URCHAS;A&% F PURCHASE OF PROPERTY WITH PRODUC710N

= $400,000 =S1OO,WOCA5H
?AYMENT
+ SW0,0WMODUC710N PAYMENT)
km
— 4962
—. .
19b3 1?64
---- . 1* n19b6 hlnafn. TOtlJl
?t-c.mrm lncOm* $100.000 $100,000 Sloo,ooo $loJo&l $lFm $Gi2ij S1 ,w;~
?Sv. tefkld. M. 80,000 ao.000 80,000 20,707
y%%”g:omm 20,000 20.000 10.000 20:000 79,293 500.OQO659;293
}00,000
09preclotlon *‘
N*I Income
10.000
4.500
5, 5CQ
10,000
4,500
5,500
Jo,ooo
4<$00
5,$00
IO,ow
4,s00
W)o
TO,wo
#,LTo9
$4,793
.%’%
427,300
45,000
514,.?93
Incim* lox”’ ● 1,430 1,430 1,430 1,420 22,353 lKI,WO 178,0?3
Cosh Payment 1oo,ooo 0 0 lW,00D
cash Flswt -91,430 8,576 8,378 46,94: ‘a99,2$ z~,420
PreI. ~erth
Q 10?w Cent S 9f,B45 S 7,360 $ 6,677 S 6,942 $29,943 $142,808 $ lol,oo5
●Expmtc Inctuda! npato?hkq axpensg, overhwd and ad VCIIWCM k%
..E@ty ~vtI b.s dl.ide,t be[Wea” Equtpmenf Account to b- ~clahd and t_*~hOfd Asc~nt ~ b*
daplmtmd, Amvms equal dlvlskm or S$0,000 In uuh account.

$of3wardatlonfo r1962 ‘~!962-~~w’=*

r.t.l Prowrt, l"c.m.```"'"' A``'' -*'"-') -::&% x$4`'~=$4'~`
bpreclatlm coulftalso be ccI@lot@ bvqvqej-atb.r methods. . ‘ . .
---- ---
1?62 C
•~SFGr 1962, Cd Poplel ion -= ‘..Y_~

hwom Ttm =. Rote

[Nat Incnmc - Allowabla D*pl*ffd ~ 0.
tCmh Flow = Dmprdotion + Net lncemo.- income Tna-Caah?wnt4nf.

. . . .. ..— — —.- .. —. —A. ——_.— .—. — ..—. — —. L.—

-.
l.”
 -3”
An.examinationof Table I shows that the purchaseoftthe property for cash

yit?lds’almost
exactly a-return of 1(%$,i.e., At”is only just w~rthwhile

since the discountingof future cash flows shows an excess of ody $1,270

over-the present investmentrequirement.

By purchasingthe property for cash of $lC0,000togetherwith a loan

of $300,000 (Table II) the net present worth is increasedby $42,137$

accordingto Mr. Pearson. This inarease is anal.y=ed

into componentparts

in Table IV. The table shows that $16,569 is due to a decrease in the

present worth of the tax paymentsand $25,568 is due to the difference

between the present worth of the payments to the loan holder and the
.
money he puts into the venture. The increase in present value due to the

tax payments is &-&questionable benefit? but the gain on the,loan requires,

further examination.

Table IV

ANALYSISOF THE INCREASE IN VALUE OF THE PROPERTY

DUE TO LOAN FINANCING COMPAHEDTO A STRAIGHTCASH PURCHASE
(FROM TABLUS I AND H)
7L:~“ ~.:~“j-.. , ~ ;:,, [; ~. :.;, T , . “. T ~: ~ ~
.“ - .,.. . . .

ITEM I.J?@ lJ& lJ@J lQ6g x366 TOTAL

UN&~D Fgfl TINE
Differencein Interest !!14,8?5 $11,201 # 7,320$ 3,221 S138 $36,755
Differencein Income Tax (6;::;;) (5,825) (3,806) (2,675) (72) (19,113)
Payment of Losn 68,799 72,68o 76,779 16,617 300,000”
Loan ‘(300,000) (300000)
Net Cash Flow Change ($227,735)$ ~ $*$zf%H +*3*
!.
.. .
P~ti ””.”””
Difi’erence.
in Interest $-14,155 $ 9,645 $ 5,703$ 2,271 $ 88$31,862-
Difference-inIncome Tax ~:,;:) (5,016) (2,966) (1,181) (%) (16,569)’
Payment of Loan s 59,243 56,625 54,129 10,600 242,57Q
LoSq (3QOOOO) -- -- ( 00000)
Ne.t’Change
---—.—.——.———..— .—— (-$- —
.——— $*$* . $m & .——
. .
..
 . .,

-4-

Piesent worth of’reoeiptof loan $300,000

Present worth of payments to loan holder
Principal $242,570
Interest 31,862 274,432.
Apparent gain in loan u

The gain on”the loan is due to the fact that interest has been paid at

the rate of 6% and yet this interestas well as the rePaYmentof PrinciP~ ,

,havebeen discountedat 10%.Z Is profit making that easy? While we may

accept that there a“remarket imperfectionsand that assets or loans have

differentvalues to differentpeople, a discrepancyof this size seems

improbable,especiallywhere the loan is obtainedas a result of bargaining

in a free’market. Is the future worth of the payments to be valued at

$274,432to the payer, while the receiptof the 10ZW iS worth 830%W0 to
.’
the payee? Students of fiumce will recognizethat this is similar to the

problem of:decidingwhether the value of a corporationis independentof

-.,
its manner ,offinancing.3 Clearly,by using 10% as the requiredrate
.. .+
througliout;Mr. Pearson supportsthe view that the value of the property
.
is dependenton its manner of financing,even if the income tax effect is

ignored. In fact; as indicatedin Table IV, in some instances,this effect

may even outweigh the income tax effect.

2
Actuallythere is.an additionalcomplicationinsofar as we have used
continuouscompoundingfor discountingwhile the loan has probablybeen
computed Oriamonthly or longer compoundingperiod._Discussion.ofthis
problem has not been introducedto avoid obscuringthe more vital elements;” ““
3See for example the section on “l~~e’costof Debt an’dEquity Funds,lt”in
.
The Managementof CorporateCapital, ed~ Ezra Solomon (GraduateSchool.of
“Business,The Universi~ of Chicago Publications: LStudiesin Business,”
... .
.T’bird Series: Chicago. Illinois: The-Free Press of Glencoe, Illinois,1959),

1- ,
 -5”
We would argue’that when an oil loan enters the picture and claims the

first receipts from an oil venture, the remainingexpect;dnet receiptshave

a substantiallyhigher risk factor . there is considerablymore uncertainty.

.
A purchasermust expect to pay more for the first barrels of oil than for the

anticipatedlater barrels which may not exist. The low risk Commandsa

higher price and thus a lower rate of return,to the purchaser (E .chas 6%).

If no risk existed, the rate of return would be limited to that on substan-

tially risk-freesecurities (such as approximately4% on governmentbonds). -

On the other hand, ‘ifrisk is high, the rate commandedwill necessarilybe

high. Besides the physicaluncertainty,there are numerous economicchanges

which may occur before productionat a later time. It is not unreasonable

to assume that the rate of return required is dependentupon the risk in-
,
volved. Thereforea higher discount rate should be used for the income

expectedto be received in the more distant years or forincome at the ,

..-
margin.

One further objection should be raised and this is the implicit

assumptionof the exclusiveassociationof this loan with this particular

oii property. IX this property does notproduce enough to satisfy the lofi

agreement,then other.assets, if available,may be appropriatedfor this

purpose. Presumablywithout such a possibilitythere would beja greater

“riskto tfielendei eindtherefore“adetitid”

for a Iiiglier
rate of interest, “:

‘he charge against thesp~cific propertyis &lerstated whenever-other

assets serve as collateralto the loan. This does not mean that Mr.
—. —. ——- ..—. —~
P@~sori?s-prkW@nta~ib:fiTekTes
no useffiI~ti~i~”tiich%fiaW&tZiE-cesV”=t
,-.
may indicate a course of action for’”thecomp~”a$ a-whole“byshowing the
j ,,
..
.:
.-— ..’
. *.
.. .

-6-
marginal effect of the transactions,but it cannot measure the present worth

of the specifi.e
assets,

Additionally,we tend to regard the rate of return requiredQn a capital

investmentas being that which is necessaryto :paya return to all long term

equities. The original10% rate would normally have already taken account

of the Interest requiredby debt financing. Thus, if a loan csn be obtained

at 6%, secured by part of the production,the’higher risk on the remainder

.
will require an interest rate high enough to make the overall rate of return

approximate1.0%. Perhaps if the company has no other property and no other

long term liabilitiesthen the method of presentationmay be acceptable.

Rather than give an alternativeanalysis for lom finsncingon this basis,

we will give a presentationfor the productionpayment where these possible

,~.
objectionsand complicatingfactors do not exist. The principlesshown for

the productionpayment can be adopted for leap financingwhere appropriate.

The differencebettieenthe v~ue of the property through financingby

way of a productionpayment as comparedto the cash payment is shown in

Table V. ~is amount of $99,735is seen to be a consequenceof a deopease

,..
of $?6,688 in the present wo’rthof the tax paymentsand a differenceof

$23,047between the discountedpresent worth of the productionpayment and

its initial cash paymentb It is the $23,047 which claims our attention.
.—. .- .
Our objectionto discountingpaymentsat 10% while{Payifiginterest-at6%

need not be repeated. Some of the other objectionscited above are not so .

importantin this case, since there is a simpl&fyingfactor,lfor we ca

 .
\ .
,-

..
.TABLE v .
I &ULYSIS@T
FIR ItiCREASEIN VALUE OF THE PROPERTYDUE’TO EROIXJC!PION
.~’ PAYMENTFINANCINGCOMPAREDTO A STRAIGHTCASH PUROHASE
(FROMTABLES I AND III)
,.
,’
:“<.
i’” ““” ““‘“
,- I 1962 lJxJ— 1964 lJx& ~ Remainder
—. TCYi’AL
lJti&P~S7’&DFoR ~ (M~
Payment to IX&&tion Payment $ 80,0C0 $ 80,w $ 80,000 $ 80,000 “$ 20,707 $ ..- 3340,707
Differencein Income Tax (25,QX) (25,090) (25,090) (25,090) [4,167) 18,200 (86,327)
produ~ion PaymentReceipt (300.0001 (300,000)
Net Change in Caeh Flow $(245,090)$ 54,91o $, 54,910 $ 54,9m $ 16,540 $:18,200 8 (45,620)

PRmEiiT
WORTH10%
Paym&t to Productiori
Payment $ 76,128 $ 68,888 $ 62,328 $ 56,400 $ 13,209 ?5 -- $276,953
t’ (2,658) -8,687 (76,688),“
Xfference in Income Tax (23,875) (a,605) (19,543) (1?,689)
I {300,000) : -: (300,000
).+
.Produ~tionPayment.X&eipt
Net “ , $(247,747) $ 47,283 $ “4z,780 $ 38,7u $ 10,52 $ 8,687’ 8 (99,735)
r

Preserd,worth of receipt of productionpayment $30&,00&

Present’worth of piyments
Gain onproduction payment m

,. .....-
..
,.

I
.. a.
8

.Supposethat one adopts the view that the method of financingdoes ’not

change the value of the property. Row does this affect the analysis? Table

VI indicatesour preferredmethod ofanalysis, which follows this assumption.4

‘he increase in net worth is equal to the tax benefit of $76,688 as qhown in

the”previousparagraphand by Table V. The analysis takes account of the

total flows of the propertywhich are all velued accordingto the-overall

iO% rate of return.5 Discountingall of these flows at 10% yields a net-

advantageof $77,958(line”5)which”belongs.tothe working interest. Next

attentionis focused on the actual cash flows of the working interest

itself. The rate which discountsthese cash flows to a net advantageof

$77,958 is then fo~de This approximates h a 12% rate. Thus line 2 of

Table VI, discountedat 12%, gives line 6, havinga present worth of $77,897.
$
Thereforewe concludethat’the additionalrisk to the working interestis”
,
compensatedby W increase of 2% in the rate of return.
r

.4
A presentationbased on similar assumptionscan be found in Lyon Terry
and Kenneth Hill, Valuation~ QQ. ——
and Gas ProducingPropertiesfor LOmI
Purposes,PetroleumDivisidn,Chase Manhattan Bank, 1953.

51t mi~t be argued’thatt&s statementis incorrectas,we.shoul.dmake

a much inclaasiveanalysisof the cash flows ~f the holder of the production
payment. This in turn may affect the value of the property. The holder of ‘
theproduction.paymenthas tax benefits insofar as.cost depletiondelays
tax paymentsbeyond the time when income would be reportedon an investment
loanbasis...Also Lt<js possible to..fig~cethe prp@u@AoWPaW9nt ~tself
by means of a loan to furtlier
complicatethe analysisof presetitworth.
Such ramificationsare ignored here as we believe that our method gives a
more workable solutionand the;answerwould not be substantiallyc’hangedby”—
‘furtherRefinements,
;$.;, ,: r:
::J , f’
,ITm’
1 1962 1965 1966
—.— Remainder T(MAL
{;;>
/j!.:
—1 ‘
y j , /,;
,.;:
1.
1’ $ 80,qIo $ 80,~” , $ 80,000 $ 80,000 $ 20,707 $ $ 34’0,70’?
‘“y”
f’!’::
,+)
,:,, .< “Produc~onPayment;

$(1OO,OOO)
8,076 $ “7,163+ $ 6,353 $ 5,634 $ 27,371A $123,300 i 77,897
1

‘.

.
. ,
 “.

summary g Corxmtsions
.
Financingof oil productionthrough external sources-undoubtedly yiekd~
,,
con&iderableadvantages. The extent and source of these advantagesare a

matter of some dispute,

of a situationas b~ing correct, it is

Before acceptingan”analysis;

importantthat the basic premises on which this analysisrests should be

clearly understood. The Pearson model has been examinedto indicate expli-

citly what was implicitlyassumed, It has been shown that PearsonQsassuinp-

ti.on. I&it present value OS the residual interestinthe productionmay’be

‘ derived by a constantmultiple times cash flow, doesnot give adequate con-

siderationto’the relativerisk involved~’We reject his premise and instead

substitutea premise which takes account of risk, i.e.s higher risks command

a higher rate of return. .Our sbustitutedanalysis indicatesthat in the

example cited by Pearson there is indeed an advantagein-financingoil prod-

ucti.on,by
— o
.-u6side sources. This adv=tage is derived primarily through tax -

the majority of cases, and are ignored.

benefits;other benefits are illusory..ln

The increase in present value occurs.mainlybecause of tax provisions .

regardingdepZetion. This advantage,therefore,is a matter of favorable

legislation,rather than good economicmanagementof a business property.

,, :
.. It i’s possible
-. to increasethe value of a propertyby a large @mount in

this manner. Consequently,the.managerialeconomistmust confer with end

defer to the tax specialist.