Introduction     Future Value     Present Value     Net Present Value I     Net Present Value II     Discount Rate   Expected NPV

   Decision Tree     Utility     Opportunity and Sunk Costs  Evaluating Oil Rights    Free Rider    Strategy

Determining Your Discount Rate...

If you apply financial techniques to your decisions on OilFinancier, you will find that your decisions will be very dependent on what discount rate you use. You will need to establish a good discount rate to be competitive. If your rate is too low, other financiers may take advantage of your requirements for lower returns. If too high, you may be walking away from too many good opportunities.

Oil companies base their discount rates on several factors, as described below:

  • the rate of inflation (the discount rate should be higher than inflation)
  • the cost of borrowing money (the discount rate should be higher than the interest rate to borrow money)
  • shareholder expectations (if shareholders get a better rate of return somewhere else, why should they invest with you?) or
  • historical investment patterns.

In OilFinancier, I have improvised three possible strategies for determining a good discount rate.

  1. Available Cash Method
  2. Share Price Rate of Return
  3. Accounting Rate of Return 

I should say that none of these methods have yet proven themselves―and as I will be mentioning later, none is perfect. But these methods are better than guessing a discount rate, and they provide a mechanism for a changing discount rate as the seminar changes. If a financier experiments with one of these strategies, he or she can post their findings on the strategies webpage.

And there may be other ideas on how to select an appropriate discount rate. I'm not going to claim being the absolute expert on this topic.

 

Available Cash Method

This method is based on how much cash you have. If you have lots, you want to put it to work rather than sit in your account to collect the 0% OilFinancier interest.

In other words, if you have lots of cash, you should be using a low discount rate to put you into more investments. With a low discount rate, you will be bidding higher for oil rights. You will be taking more risks. You will be accepting deals that seem a little unfair to you. This is to get your extra cash working, not sitting idle. 

On the other hand, if you have just a little cash, you should be careful with it. You shouldn't bid so much on oil rights which may take a long time to bear fruit; you should stay with development drilling; and you should work your deals to get a little edge. You should be waiting for that good deal to come your way.

While waiting for that good deal, you might find it isn't coming your way. But your cash is growing. With this cash growth comes a lower discount rate, which means you'll be considering more investment opportunities. In essence, the Available Cash Method becomes self-regulating, and you'll be taking on appropriate levels of risk depending on your financial situation.

To enact such a strategy, draw a straight-line graph based on these data points: (1) set a discount rate of 2.5% to 3.5% for zero cash, and (2) set a the zero discount rate for somewhere between half a million and two million dollars of cash. The graph below shows two different strategies:

In both strategies, the financier loosens up as his cash accumulates. When he spends some of that cash―whether by buying oil rights, drilling successful wells, or drilling unsuccessful wells―he becomes a more conservative investor with the higher discount rate. After this investment, his cash will slowly build up again which means a slowly decreasing discount rate until he makes another investment.

Strategy 2 is more aggressive than Strategy 1. For example, each strategy would start the seminar with $100,000. Strategy #1 would be using a discount rate of 2.9%; Strategy 2 would be using 2.6%. So for the first oil right to be auctioned off, Strategy 2 should be bidding a little bit more than Strategy #1, thus winning the first right.

If we assume both strategies are sitting on $1m, Strategy 1 would be using a discount rate of 1.5% which favors development drilling. Strategy 2, on the other hand, would be using a discount rate of 1.0%, which is low enough to consider exploration drilling. If Strategy 2 has no development opportunities, he should do some exploration. On the other hand, Strategy 1 will wait until his cash builds up until he considers exploration. 

You may even want to modify this method by using cash plus "x" days of cash flow to base your discount rate.

I see two problems with this method. First, in the early seminar, it might make you too cautious and let other financiers get some cash flow happening that  will give them a jump on you.  Second, if you are a leader in the late seminar, you could have a cash flow of $200,000 per day. This means the discount rate changes quite quickly in a short time, making it actually quite useless for discerning the better investments in these times. 

Share Price Rate of Return

Your share price is actually a very reasonable indicator of how well you have done in your OilFinancier seminar. You can use the change in your share price to calculate your rate of return by using the well known compound interest equation:

SP2 = SP1 ´ (1 + ROR)t

where:

SP1 is the share price at Time 1

SP2 is the share price at Time 2

t is the time (for OilFinancier, it will be OF Days)

ROR is the rate of return (in a decimal)

If we rearrange this equation, we have:

ROR = 10(log SP2¸ SP1) ¸ t  - 1

For example, let’s assume your share was $0.25 on Day 1 and you built it up $1.25 by Day 50.

Here is rate of return

ROR = 10(log 1.25¸ 0.25) ¸ 50 - 1

ROR = 10(log 5) ¸ 50 - 1

ROR = 100.6990 ¸ 50 - 1

ROR = 100.0140 - 1

ROR = 1.033 - 1

ROR = 0.033 or 3.3%

In OilFinancier, I can see a couple of problems with substituting ROR directly into your discount rate. First, a successful drilling program will yield a higher ROR, which means you become a more conservative investor despite having more resources for reinvestment. You will be accumulating cash and likely not spending it. Second, an unsuccessful drilling program will yield a lower ROR, which puts you into riskier investments, which is probably not where you should be with your limited cash. 

Despite the counter-intuitive cause-and-effect by determining your discount rate in this way, it still has excellent merit: If you have proven to produce an ROR of 2.3%, why should you settle for a deal that gives you less?

If you use this method, you might want to set your discount rate at about 50% of your calculated ROR. I think this will create some moderation.

And I also recommend keeping your SP1 and SP2 values about 30 to 80 OF days apart to calculate a representative ROR of your past performance.

Below is a ROR graph of the top financiers for OF3 after they had gone through 2/3 of their seminar.

The ROR's are high at Day 70 because the financiers had discovered the first shallow oilfield discovery and were still drilling lots of infill wells (high success rate). After this field became more delineated, OF3 moved into more exploration drilling which resulted in lower RORs. About Day 140, the first deep hostile oilfield was discovered, and ROR's increased after that. Towards the Day 180, the deep hostile oilfield is drilled out, and you can see the RORs starting to decline.

From this graph, you can see OilFinancier RORs fluctuate between 1% to 5%, which should give you an idea of possible discount rates to use.

It would, however, be rather difficult to consistently run at 4% throughout the entire seminar. OilFinancier was not designed with this high of return--and OF3 fell within this design parameter.

I should just also add that I didn't think OF3 was as competitive as it could have been. I think leading financiers in competitive seminars will experience ROR's of only 2%. But this is just my hypothesis; we shall soon see when I get a real competitive seminar.   

 

 

Accounting Rate of Return

This was my first method that I developed to help financiers with selecting a discount rate. Its biggest problems are (1) it is fairly cumbersome to use, (2) requires some knowledge of accounting procedures, and (3) requires making some estimates in depreciation.

I can't see this method providing a significantly different discount rate than the Share Price Rate of Return. I really don't recommend anyone using it.

But I will leave it posted for those who are interested. 


The Example

To keep things simple, let’s assume that you are just starting the game and you are the only partner in a shallow well. You are going to pay $100,000 to drill this well, and you are going to receive all the revenues. For the purpose of this example we will ignore the three days required to drill this well. The well finds oil at the shallow depth and your initial revenues are $13,000 per day.

In proper accounting, one must depreciate an asset over its estimated lifetime. In this sense, the expense of the asset is shared by all the fiscal periods for which it is being used, not just the fiscal period when the asset is purchased. We have decided to depreciate all our assets (the oil rights we buy and the wells we drill) by 4% per OF day.

So in our first day, we have $13,000 in revenue from our shallow well. We also depreciate ("write-off") our asset by 4%, which is $4,000. [$100,000 ´  0.04].

Our earnings are the revenues minus the expenses of depreciation of our assets, which comes to $9,000 [$13,000 – $4,000].

Our rate of return is our earnings divided by our assets, which calculates to 9.0% [$9,000 ¸  $100,000 ´ 100%]. This figure becomes our discount rate because we have proven that we can earn this kind of return—and not to accept a deal that provides a negative Net Present Value (NPV) using this rate of return.

Let’s calculate our rate of return for the second day.

The first item we must account for is that the book value of our asset has shrunk to $96,000 [$100,000 – $4,000]. So our depreciation expense is recalculated to $3,840 [$96,000 ´ 0.04].

But as oil wells decline in production, our shallow well declines by 2.5% to $12,675 [$13,000 – (1– 2.5/100)]. So our earnings are $8,835 [$12,675 – $3,840].

Our proven rate of return for our second day has increased slightly to 9.2% [$8,835 ¸ $96,000 ´ 100%].

Just to reinforce the method, let’s do a third day.

  • Book value of asset: $92,160 [$96,000 –$3,840]
  • Depreciation Expense: $3,686 [$92,160 ´ 0.04]
  • Revenue: $12,358 [$12,675 ´ (1 – 2.5/100)]
  • Earnings: $8,672 [$12,358 – 3,686]
  • Rate of Return: 9.4% [$8,672 ¸ $92,160 ´ 100%]

While this example is very good for determining your discount rate, I want to clarify that if you happen to have a rate of return of 9% per OF day, you are either having more luck than brains, finding suckers for partners, or creating some innovative accounting procedures. The game is not designed to produce this kind of return. To further bring our example into OilFinancier reality, we are going to drill another shallow well except that this well will be a duster.

  • Our assets are now the book values of the two wells: $188,474 [($92,160 – $3,686) + $100,000]
  • Depreciation expense: $7,538 [$188,474 ´ 0.04]
  • Revenue: $12,049 [$12,358 – (1 – 2.5/100)]
  • Earnings: $4,511 [$12,049 – 7,538]
  • Rate of Return: 2.4% [$4,511 ¸ $188,474 ´ 100%]

There! That 2.4% per day is a more reasonable return of what you will see in OilFinancier (when it gets to development drilling phase)! I sure didn’t want to get anyone too excited.

Summary

One of the points of this whole exercise was to prove that the discount rate was not just an arbitrary number—you can calculate it. But, as you may have surmised, the discount rate is dependent on the rate we choose to depreciate our assets, and this depreciation rate seems to be an arbitrary number. I have three things to say about this matter:

  • First, your calculated discount rate would not change that much if you used 3% or 5% as your depreciation rate. Use the previous examples to rework the rate of return using these depreciation rates and see for yourself. If your rate of return is a bit off, it won’t make that much difference in the decisions you make in the seminar for the long term.
  • Second, using a discount rate based on a reasonable estimated depreciation rate is better than using a discount rate derived by guesswork.
  • Third, if you make a reasonable estimate of the depreciation rate of your assets—and stick with that estimate—your calculations will be very close to your true rate of return over the long term.

Remember that depreciation is only an estimate: for most assets, there is no exact way to determine how long they will last. Create some decline spreadsheets for shallow, intermediate, and deep wells to determine a reasonable depreciation rate. If you want to get into some detailed financial analyses, you might want to create separate asset accounts, using a different depreciation rate, for each kind of well—and your oil right purchases. I suspect most financiers will not want to get into that much accounting—but it could be good practice.

Download the ROR spreadsheet.

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