Discount rates and price forecasts for upstream petroleum valuations

For their appraisals, most petroleum companies use discount rates that implicitly account for riskiness of projects. They draw this rate from their Weighted Average Cost of Capital (WACC) and then apply it to expected future cash flows. Yet, they forecast cash flows using expected prices that are sometimes at odds with the assumptions in WACC. More specifically, the risk-premiums within the price forecasts and the discount rate are of similar nature and should be compatible, but with the multitude of technical and market risks, it is not clear how to estimate these premiums. In this paper, we use the Schwartz and Smith (2000) two-factor price process and implied method of parameter estimation to discuss a consistent valuation framework. We determine the discount rate together with analysts’ long-term
prices forecasts. The suggested methodology is particularly useful in valuation of long-term capital investments.