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These excerpts taken from the DVN 10-K filed Feb 27, 2009. Judgments
and Assumptions
The discounted present value of future net revenues for our
proved oil, gas and NGL reserves is a major component of the
ceiling calculation, and represents the component that requires
the most subjective judgments. Estimates of reserves are
forecasts based on engineering data, projected future rates of
production and the timing of future expenditures. The process of
estimating oil, gas and NGL reserves requires substantial
judgment, resulting in imprecise determinations, particularly
for new discoveries. Different reserve engineers may make
different estimates of reserve quantities based on the same
data. Certain of our reserve estimates are prepared or audited
by outside petroleum consultants, while other reserve estimates
are prepared by our engineers. See Note 20 of the
accompanying consolidated financial statements for a summary of
the amount of our reserves that are prepared or audited by
outside petroleum consultants.
The passage of time provides more qualitative information
regarding estimates of reserves, and revisions are made to prior
estimates to reflect updated information. In the past five
years, annual performance revisions to our reserve estimates,
which have been both increases and decreases in individual
years, have averaged less than 2% of the previous year’s
estimate. However, there can be no assurance that more
significant revisions will not be necessary in the future. If
future significant revisions are necessary that reduce
previously estimated reserve quantities, it could result in a
full cost property writedown. In addition to the impact of the
estimates of proved reserves on the calculation of the ceiling,
estimates of proved reserves are also a significant component of
the calculation of DD&A.
While the quantities of proved reserves require substantial
judgment, the associated prices of oil, gas and NGL reserves,
and the applicable discount rate, that are used to calculate the
discounted present value of the reserves do not require
judgment. The ceiling calculation dictates that a 10% discount
factor be used and that
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prices and costs in effect as of the last day of the period are
held constant indefinitely. Therefore, the future net revenues
associated with the estimated proved reserves are not based on
our assessment of future prices or costs. Rather, they are based
on such prices and costs in effect as of the end of each quarter
when the ceiling calculation is performed. In calculating the
ceiling, we adjust the end-of-period price by the effect of
derivative contracts in place that qualify for hedge accounting
treatment. This adjustment requires little judgment as the
end-of-period price is adjusted using the contract prices for
such hedges. None of our outstanding derivative contracts at
December 31, 2008 qualified for hedge accounting treatment.
Because the ceiling calculation dictates that prices in effect
as of the last day of the applicable quarter are held constant
indefinitely, and requires a 10% discount factor, the resulting
value is not indicative of the true fair value of the reserves.
Oil and gas prices have historically been volatile. On any
particular day at the end of a quarter, prices can be either
substantially higher or lower than our long-term price forecast
that is a barometer for true fair value. Therefore, oil and gas
property writedowns that result from applying the full cost
ceiling limitation, and that are caused by fluctuations in price
as opposed to reductions to the underlying quantities of
reserves, should not be viewed as absolute indicators of a
reduction of the ultimate value of the related reserves.
Because of the volatile nature of oil and gas prices, it is not
possible to predict the timing or magnitude of full cost
writedowns. However, considering current and near-term estimates
of oil and gas prices, such writedowns may be more likely to
occur during 2009 than in recent periods.
The SEC recently revised the requirement to use quarter-end
prices to calculate the full cost ceiling. Beginning on
December 31, 2009, the ceiling will be calculated using a
12-month
average price. See “Modernization of Oil and Gas
Reporting” for more information on the SEC’s revised
rules.
Judgments
and Assumptions
The discounted present value of future net revenues for our
proved oil, gas and NGL reserves is a major component of the
ceiling calculation, and represents the component that requires
the most subjective judgments. Estimates of reserves are
forecasts based on engineering data, projected future rates of
production and the timing of future expenditures. The process of
estimating oil, gas and NGL reserves requires substantial
judgment, resulting in imprecise determinations, particularly
for new discoveries. Different reserve engineers may make
different estimates of reserve quantities based on the same
data. Certain of our reserve estimates are prepared or audited
by outside petroleum consultants, while other reserve estimates
are prepared by our engineers. See Note 20 of the
accompanying consolidated financial statements for a summary of
the amount of our reserves that are prepared or audited by
outside petroleum consultants.
The passage of time provides more qualitative information
regarding estimates of reserves, and revisions are made to prior
estimates to reflect updated information. In the past five
years, annual performance revisions to our reserve estimates,
which have been both increases and decreases in individual
years, have averaged less than 2% of the previous year’s
estimate. However, there can be no assurance that more
significant revisions will not be necessary in the future. If
future significant revisions are necessary that reduce
previously estimated reserve quantities, it could result in a
full cost property writedown. In addition to the impact of the
estimates of proved reserves on the calculation of the ceiling,
estimates of proved reserves are also a significant component of
the calculation of DD&A.
While the quantities of proved reserves require substantial
judgment, the associated prices of oil, gas and NGL reserves,
and the applicable discount rate, that are used to calculate the
discounted present value of the reserves do not require
judgment. The ceiling calculation dictates that a 10% discount
factor be used and that
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prices and costs in effect as of the last day of the period are
held constant indefinitely. Therefore, the future net revenues
associated with the estimated proved reserves are not based on
our assessment of future prices or costs. Rather, they are based
on such prices and costs in effect as of the end of each quarter
when the ceiling calculation is performed. In calculating the
ceiling, we adjust the end-of-period price by the effect of
derivative contracts in place that qualify for hedge accounting
treatment. This adjustment requires little judgment as the
end-of-period price is adjusted using the contract prices for
such hedges. None of our outstanding derivative contracts at
December 31, 2008 qualified for hedge accounting treatment.
Because the ceiling calculation dictates that prices in effect
as of the last day of the applicable quarter are held constant
indefinitely, and requires a 10% discount factor, the resulting
value is not indicative of the true fair value of the reserves.
Oil and gas prices have historically been volatile. On any
particular day at the end of a quarter, prices can be either
substantially higher or lower than our long-term price forecast
that is a barometer for true fair value. Therefore, oil and gas
property writedowns that result from applying the full cost
ceiling limitation, and that are caused by fluctuations in price
as opposed to reductions to the underlying quantities of
reserves, should not be viewed as absolute indicators of a
reduction of the ultimate value of the related reserves.
Because of the volatile nature of oil and gas prices, it is not
possible to predict the timing or magnitude of full cost
writedowns. However, considering current and near-term estimates
of oil and gas prices, such writedowns may be more likely to
occur during 2009 than in recent periods.
The SEC recently revised the requirement to use quarter-end
prices to calculate the full cost ceiling. Beginning on
December 31, 2009, the ceiling will be calculated using a
12-month
average price. See “Modernization of Oil and Gas
Reporting” for more information on the SEC’s revised
rules.
Judgments
and Assumptions
The estimates of the fair values of our derivative instruments
require substantial judgment. We estimate the fair values of our
oil and gas derivative financial instruments primarily by using
internal discounted cash flow calculations. The most significant
variable to our cash flow calculations is our estimate of future
commodity prices. We base our estimate of future prices upon
published forward commodity price curves such as the Inside FERC
Henry Hub forward curve for gas instruments and the NYMEX West
Texas Intermediate forward curve for oil instruments. Another
key input to our cash flow calculations is our estimate of
volatility for these forward curves, which we base primarily
upon implied volatility. The resulting estimated future cash
inflows or outflows over the lives of the contracts are
discounted using LIBOR and money market futures rates for the
first year and money market futures and swap rates thereafter.
These pricing and discounting variables are sensitive to the
period of the contract and market volatility as well as changes
in forward prices and regional price differentials.
We estimate the fair values of our interest rate swap financial
instruments primarily by using internal discounted cash flow
calculations based upon forward interest-rate yields. The most
significant variable to our cash flow calculations is our
estimate of future interest rate yields. We base our estimate of
future yields upon our own internal model that utilizes forward
curves such as the LIBOR or the Federal Funds Rate provided by
third parties. Another key input to our cash flow calculations
is our estimate of volatility for these forward yields, which we
base primarily upon implied volatility. The resulting estimated
future cash inflows or outflows over the lives of the contracts
are discounted using LIBOR and money market futures rates for
the first year and money market futures and swap rates
thereafter. These yield and discounting variables are sensitive
to the period of the contract and market volatility as well as
changes in forward interest rate yields.
From time to time, we validate our valuation techniques by
comparing our internally generated fair value estimates with
those obtained from contract counterparties
and/or
brokers.
In spite of the recent turmoil in the financial markets,
counterparty credit risk has not had a significant effect on our
cash flow calculations and derivative valuations. This is
primarily the result of two factors. First, we have mitigated
our exposure to any single counterparty by contracting with
numerous counterparties. Our commodity derivative contracts are
held with eight separate counterparties, and our interest rate
derivative contracts are held with five separate counterparties.
Second, our derivative contracts generally require cash
collateral to be posted if either our or the counterparty’s
credit rating falls below “investment grade”. The
threshold for collateral posting decreases as the debt rating
falls further below investment grade. Such thresholds generally
range from zero to $50 million for the majority of our
contracts. As of December 31, 2008, the credit ratings of
all our counterparties were investment grade.
Quarterly changes in our derivative fair value estimates have
only a minimal impact on our liquidity, capital resources or
results of operations, as long as the derivative instruments
qualify for hedge accounting treatment. Changes in the fair
values of derivatives that do not qualify for hedge accounting
treatment can have a significant impact on our results of
operations, but generally will not impact our liquidity or
capital resources.
Settlements of derivative instruments, regardless of whether
they qualify for hedge accounting, do have an impact on our
liquidity and results of operations. Generally, if actual market
prices are higher than the price of the derivative instruments,
our net earnings and cash flow from operations will be lower
relative to the results that would have occurred absent these
instruments. The opposite is also true. Additional information
regarding the effects that changes in market prices can have on
our derivative financial instruments, net earnings and cash flow
from operations is included in “Item 7A. Quantitative
and Qualitative Disclosures about Market Risk.”
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Judgments
and Assumptions
The estimates of the fair values of our derivative instruments
require substantial judgment. We estimate the fair values of our
oil and gas derivative financial instruments primarily by using
internal discounted cash flow calculations. The most significant
variable to our cash flow calculations is our estimate of future
commodity prices. We base our estimate of future prices upon
published forward commodity price curves such as the Inside FERC
Henry Hub forward curve for gas instruments and the NYMEX West
Texas Intermediate forward curve for oil instruments. Another
key input to our cash flow calculations is our estimate of
volatility for these forward curves, which we base primarily
upon implied volatility. The resulting estimated future cash
inflows or outflows over the lives of the contracts are
discounted using LIBOR and money market futures rates for the
first year and money market futures and swap rates thereafter.
These pricing and discounting variables are sensitive to the
period of the contract and market volatility as well as changes
in forward prices and regional price differentials.
We estimate the fair values of our interest rate swap financial
instruments primarily by using internal discounted cash flow
calculations based upon forward interest-rate yields. The most
significant variable to our cash flow calculations is our
estimate of future interest rate yields. We base our estimate of
future yields upon our own internal model that utilizes forward
curves such as the LIBOR or the Federal Funds Rate provided by
third parties. Another key input to our cash flow calculations
is our estimate of volatility for these forward yields, which we
base primarily upon implied volatility. The resulting estimated
future cash inflows or outflows over the lives of the contracts
are discounted using LIBOR and money market futures rates for
the first year and money market futures and swap rates
thereafter. These yield and discounting variables are sensitive
to the period of the contract and market volatility as well as
changes in forward interest rate yields.
From time to time, we validate our valuation techniques by
comparing our internally generated fair value estimates with
those obtained from contract counterparties
and/or
brokers.
In spite of the recent turmoil in the financial markets,
counterparty credit risk has not had a significant effect on our
cash flow calculations and derivative valuations. This is
primarily the result of two factors. First, we have mitigated
our exposure to any single counterparty by contracting with
numerous counterparties. Our commodity derivative contracts are
held with eight separate counterparties, and our interest rate
derivative contracts are held with five separate counterparties.
Second, our derivative contracts generally require cash
collateral to be posted if either our or the counterparty’s
credit rating falls below “investment grade”. The
threshold for collateral posting decreases as the debt rating
falls further below investment grade. Such thresholds generally
range from zero to $50 million for the majority of our
contracts. As of December 31, 2008, the credit ratings of
all our counterparties were investment grade.
Quarterly changes in our derivative fair value estimates have
only a minimal impact on our liquidity, capital resources or
results of operations, as long as the derivative instruments
qualify for hedge accounting treatment. Changes in the fair
values of derivatives that do not qualify for hedge accounting
treatment can have a significant impact on our results of
operations, but generally will not impact our liquidity or
capital resources.
Settlements of derivative instruments, regardless of whether
they qualify for hedge accounting, do have an impact on our
liquidity and results of operations. Generally, if actual market
prices are higher than the price of the derivative instruments,
our net earnings and cash flow from operations will be lower
relative to the results that would have occurred absent these
instruments. The opposite is also true. Additional information
regarding the effects that changes in market prices can have on
our derivative financial instruments, net earnings and cash flow
from operations is included in “Item 7A. Quantitative
and Qualitative Disclosures about Market Risk.”
Table of Contents
Judgments
and Assumptions
There are various assumptions we make in determining the fair
values of an acquired company’s assets and liabilities. The
most significant assumptions, and the ones requiring the most
judgment, involve the estimated fair values of the oil and gas
properties acquired. To determine the fair values of these
properties, we prepare estimates of oil, gas and NGL reserves.
These estimates are based on work performed by our engineers and
that of outside consultants. The judgments associated with these
estimated reserves are described earlier in this section in
connection with the full cost ceiling calculation.
However, there are factors involved in estimating the fair
values of acquired oil, gas and NGL properties that require more
judgment than that involved in the full cost ceiling
calculation. As stated above, the full cost ceiling calculation
applies end-of-period price and cost information to the reserves
to arrive at the ceiling amount. By contrast, the fair value of
reserves acquired in a business combination must be based on our
estimates of future oil, gas and NGL prices. Our estimates of
future prices are based on our own analysis of pricing trends.
These estimates are based on current data obtained with regard
to regional and worldwide supply and demand dynamics such as
economic growth forecasts. They are also based on industry data
regarding gas storage availability, drilling rig activity,
changes in delivery capacity, trends in regional pricing
differentials and other fundamental analysis. Forecasts of
future prices from independent third parties are noted when we
make our pricing estimates.
We estimate future prices to apply to the estimated reserve
quantities acquired, and estimate future operating and
development costs, to arrive at estimates of future net
revenues. For estimated proved reserves, the future net revenues
are then discounted using a rate determined appropriate at the
time of the business combination based upon our cost of capital.
We also apply these same general principles to estimate the fair
value of unproved properties acquired in a business combination.
These unproved properties generally represent the value of
probable and possible reserves. Because of their very nature,
probable and possible reserve estimates are more imprecise than
those of proved reserves. To compensate for the inherent risk of
estimating and valuing unproved reserves, the discounted future
net revenues of probable and possible reserves are reduced by
what we consider to be an appropriate risk-weighting factor in
each particular instance. It is common for the discounted future
net revenues of probable and possible reserves to be reduced by
factors ranging from 30% to 80% to arrive at what we consider to
be the appropriate fair values.
Generally, in our business combinations, the determination of
the fair values of oil and gas properties requires much more
judgment than the fair values of other assets and liabilities.
The acquired companies commonly have long-term debt that we
assume in the acquisition, and this debt must be recorded at the
estimated fair value as if we had issued such debt. However,
significant judgment on our behalf is usually not required in
these situations due to the existence of comparable market
values of debt issued by peer companies.
Except for the 2002 acquisition of Mitchell Energy &
Development Corp., our mergers and acquisitions have involved
other entities whose operations were predominantly in the area
of exploration, development and
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production activities related to oil and gas properties.
However, in addition to exploration, development and production
activities, Mitchell’s business also included substantial
marketing and midstream activities. Therefore, a portion of the
Mitchell purchase price was allocated to the fair value of
Mitchell’s marketing and midstream facilities and
equipment. This consisted primarily of natural gas processing
plants and natural gas pipeline systems.
The Mitchell midstream assets primarily serve gas producing
properties that we also acquired from Mitchell. Therefore,
certain of the assumptions regarding future operations of the
gas producing properties were also integral to the value of the
midstream assets. For example, future quantities of gas
estimated to be processed by natural gas processing plants were
based on the same estimates used to value the proved and
unproved gas producing properties. Future expected prices for
marketing and midstream product sales were also based on price
cases consistent with those used to value the oil and gas
producing assets acquired from Mitchell. Based on historical
costs and known trends and commitments, we also estimated future
operating and capital costs of the marketing and midstream
assets to arrive at estimated future cash flows. These cash
flows were discounted at rates consistent with those used to
discount future net cash flows from oil and gas producing assets
to arrive at our estimated fair value of the marketing and
midstream facilities and equipment.
In addition to the valuation methods described above, we perform
other quantitative analyses to support the indicated value in
any business combination. These analyses include information
related to comparable companies, comparable transactions and
premiums paid.
In a comparable companies analysis, we review the public stock
market trading multiples for selected publicly traded
independent exploration and production companies with comparable
financial and operating characteristics. Such characteristics
are market capitalization, location of proved reserves and the
characterization of those reserves that we deem to be similar to
those of the party to the proposed business combination. We
compare these comparable company multiples to the proposed
business combination company multiples for reasonableness.
In a comparable transactions analysis, we review certain
acquisition multiples for selected independent exploration and
production company transactions and oil and gas asset packages
announced recently. We compare these comparable transaction
multiples to the proposed business combination transaction
multiples for reasonableness.
In a premiums paid analysis, we use a sample of selected
independent exploration and production company transactions in
addition to selected transactions of all publicly traded
companies announced recently, to review the premiums paid to the
price of the target one day, one week and one month prior to the
announcement of the transaction. We use this information to
determine the mean and median premiums paid and compare them to
the proposed business combination premium for reasonableness.
While these estimates of fair value for the various assets
acquired and liabilities assumed have no effect on our liquidity
or capital resources, they can have an effect on the future
results of operations. Generally, the higher the fair value
assigned to both the oil and gas properties and non-oil and gas
properties, the lower future net earnings will be as a result of
higher future depreciation, depletion and amortization expense.
Also, a higher fair value assigned to the oil and gas
properties, based on higher future estimates of oil and gas
prices, will increase the likelihood of a full cost ceiling
writedown in the event that subsequent oil and gas prices drop
below our price forecast that was used to originally determine
fair value. A full cost ceiling writedown would have no effect
on our liquidity or capital resources in that period because it
is a noncash charge, but it would adversely affect results of
operations. As discussed in “Item 7. Management’s
Discussion and Analysis of Financial Condition and Results of
Operations — Capital Resources, Uses and
Liquidity,” in calculating our debt-to-capitalization ratio
under our credit agreement, total capitalization is adjusted to
add back noncash financial writedowns such as full cost ceiling
property impairments or goodwill impairments.
Our estimates of reserve quantities are one of the many
estimates that are involved in determining the appropriate fair
value of the oil and gas properties acquired in a business
combination. As previously disclosed in our discussion of the
full cost ceiling calculations, during the past five years, our
annual performance revisions to our reserve estimates have
averaged less than 2%. As discussed in the preceding paragraphs,
there
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are numerous estimates in addition to reserve quantity estimates
that are involved in determining the fair value of oil and gas
properties acquired in a business combination. The
inter-relationship of these estimates makes it impractical to
provide additional quantitative analyses of the effects of
changes in these estimates.
Judgments
and Assumptions
There are various assumptions we make in determining the fair
values of an acquired company’s assets and liabilities. The
most significant assumptions, and the ones requiring the most
judgment, involve the estimated fair values of the oil and gas
properties acquired. To determine the fair values of these
properties, we prepare estimates of oil, gas and NGL reserves.
These estimates are based on work performed by our engineers and
that of outside consultants. The judgments associated with these
estimated reserves are described earlier in this section in
connection with the full cost ceiling calculation.
However, there are factors involved in estimating the fair
values of acquired oil, gas and NGL properties that require more
judgment than that involved in the full cost ceiling
calculation. As stated above, the full cost ceiling calculation
applies end-of-period price and cost information to the reserves
to arrive at the ceiling amount. By contrast, the fair value of
reserves acquired in a business combination must be based on our
estimates of future oil, gas and NGL prices. Our estimates of
future prices are based on our own analysis of pricing trends.
These estimates are based on current data obtained with regard
to regional and worldwide supply and demand dynamics such as
economic growth forecasts. They are also based on industry data
regarding gas storage availability, drilling rig activity,
changes in delivery capacity, trends in regional pricing
differentials and other fundamental analysis. Forecasts of
future prices from independent third parties are noted when we
make our pricing estimates.
We estimate future prices to apply to the estimated reserve
quantities acquired, and estimate future operating and
development costs, to arrive at estimates of future net
revenues. For estimated proved reserves, the future net revenues
are then discounted using a rate determined appropriate at the
time of the business combination based upon our cost of capital.
We also apply these same general principles to estimate the fair
value of unproved properties acquired in a business combination.
These unproved properties generally represent the value of
probable and possible reserves. Because of their very nature,
probable and possible reserve estimates are more imprecise than
those of proved reserves. To compensate for the inherent risk of
estimating and valuing unproved reserves, the discounted future
net revenues of probable and possible reserves are reduced by
what we consider to be an appropriate risk-weighting factor in
each particular instance. It is common for the discounted future
net revenues of probable and possible reserves to be reduced by
factors ranging from 30% to 80% to arrive at what we consider to
be the appropriate fair values.
Generally, in our business combinations, the determination of
the fair values of oil and gas properties requires much more
judgment than the fair values of other assets and liabilities.
The acquired companies commonly have long-term debt that we
assume in the acquisition, and this debt must be recorded at the
estimated fair value as if we had issued such debt. However,
significant judgment on our behalf is usually not required in
these situations due to the existence of comparable market
values of debt issued by peer companies.
Except for the 2002 acquisition of Mitchell Energy &
Development Corp., our mergers and acquisitions have involved
other entities whose operations were predominantly in the area
of exploration, development and
Table of Contents
production activities related to oil and gas properties.
However, in addition to exploration, development and production
activities, Mitchell’s business also included substantial
marketing and midstream activities. Therefore, a portion of the
Mitchell purchase price was allocated to the fair value of
Mitchell’s marketing and midstream facilities and
equipment. This consisted primarily of natural gas processing
plants and natural gas pipeline systems.
The Mitchell midstream assets primarily serve gas producing
properties that we also acquired from Mitchell. Therefore,
certain of the assumptions regarding future operations of the
gas producing properties were also integral to the value of the
midstream assets. For example, future quantities of gas
estimated to be processed by natural gas processing plants were
based on the same estimates used to value the proved and
unproved gas producing properties. Future expected prices for
marketing and midstream product sales were also based on price
cases consistent with those used to value the oil and gas
producing assets acquired from Mitchell. Based on historical
costs and known trends and commitments, we also estimated future
operating and capital costs of the marketing and midstream
assets to arrive at estimated future cash flows. These cash
flows were discounted at rates consistent with those used to
discount future net cash flows from oil and gas producing assets
to arrive at our estimated fair value of the marketing and
midstream facilities and equipment.
In addition to the valuation methods described above, we perform
other quantitative analyses to support the indicated value in
any business combination. These analyses include information
related to comparable companies, comparable transactions and
premiums paid.
In a comparable companies analysis, we review the public stock
market trading multiples for selected publicly traded
independent exploration and production companies with comparable
financial and operating characteristics. Such characteristics
are market capitalization, location of proved reserves and the
characterization of those reserves that we deem to be similar to
those of the party to the proposed business combination. We
compare these comparable company multiples to the proposed
business combination company multiples for reasonableness.
In a comparable transactions analysis, we review certain
acquisition multiples for selected independent exploration and
production company transactions and oil and gas asset packages
announced recently. We compare these comparable transaction
multiples to the proposed business combination transaction
multiples for reasonableness.
In a premiums paid analysis, we use a sample of selected
independent exploration and production company transactions in
addition to selected transactions of all publicly traded
companies announced recently, to review the premiums paid to the
price of the target one day, one week and one month prior to the
announcement of the transaction. We use this information to
determine the mean and median premiums paid and compare them to
the proposed business combination premium for reasonableness.
While these estimates of fair value for the various assets
acquired and liabilities assumed have no effect on our liquidity
or capital resources, they can have an effect on the future
results of operations. Generally, the higher the fair value
assigned to both the oil and gas properties and non-oil and gas
properties, the lower future net earnings will be as a result of
higher future depreciation, depletion and amortization expense.
Also, a higher fair value assigned to the oil and gas
properties, based on higher future estimates of oil and gas
prices, will increase the likelihood of a full cost ceiling
writedown in the event that subsequent oil and gas prices drop
below our price forecast that was used to originally determine
fair value. A full cost ceiling writedown would have no effect
on our liquidity or capital resources in that period because it
is a noncash charge, but it would adversely affect results of
operations. As discussed in “Item 7. Management’s
Discussion and Analysis of Financial Condition and Results of
Operations — Capital Resources, Uses and
Liquidity,” in calculating our debt-to-capitalization ratio
under our credit agreement, total capitalization is adjusted to
add back noncash financial writedowns such as full cost ceiling
property impairments or goodwill impairments.
Our estimates of reserve quantities are one of the many
estimates that are involved in determining the appropriate fair
value of the oil and gas properties acquired in a business
combination. As previously disclosed in our discussion of the
full cost ceiling calculations, during the past five years, our
annual performance revisions to our reserve estimates have
averaged less than 2%. As discussed in the preceding paragraphs,
there
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are numerous estimates in addition to reserve quantity estimates
that are involved in determining the fair value of oil and gas
properties acquired in a business combination. The
inter-relationship of these estimates makes it impractical to
provide additional quantitative analyses of the effects of
changes in these estimates.
Judgments
and Assumptions
The annual impairment test requires us to estimate the fair
values of our own assets and liabilities. Because quoted market
prices are not available for Devon’s reporting units, the
fair values of the reporting units are estimated in a manner
similar to the process described above for a business
combination. Therefore, considerable judgment similar to that
described above in connection with estimating the fair value of
an acquired company in a business combination is also required
to assess goodwill for impairment.
Generally, the higher the fair value assigned to both the oil
and gas properties and non-oil and gas properties, the lower
goodwill would be. A lower goodwill value decreases the
likelihood of an impairment charge. However, unfavorable changes
in reserves or in our price forecast would increase the
likelihood of a goodwill impairment charge. A goodwill
impairment charge would have no effect on liquidity or capital
resources. However, it would adversely affect our results of
operations in that period.
Due to the inter-relationship of the various estimates involved
in assessing goodwill for impairment, it is impractical to
provide quantitative analyses of the effects of potential
changes in these estimates, other than to note the historical
average changes in our reserve estimates previously set forth.
Judgments
and Assumptions
The annual impairment test requires us to estimate the fair
values of our own assets and liabilities. Because quoted market
prices are not available for Devon’s reporting units, the
fair values of the reporting units are estimated in a manner
similar to the process described above for a business
combination. Therefore, considerable judgment similar to that
described above in connection with estimating the fair value of
an acquired company in a business combination is also required
to assess goodwill for impairment.
Generally, the higher the fair value assigned to both the oil
and gas properties and non-oil and gas properties, the lower
goodwill would be. A lower goodwill value decreases the
likelihood of an impairment charge. However, unfavorable changes
in reserves or in our price forecast would increase the
likelihood of a goodwill impairment charge. A goodwill
impairment charge would have no effect on liquidity or capital
resources. However, it would adversely affect our results of
operations in that period.
Due to the inter-relationship of the various estimates involved
in assessing goodwill for impairment, it is impractical to
provide quantitative analyses of the effects of potential
changes in these estimates, other than to note the historical
average changes in our reserve estimates previously set forth.
Judgments and Assumptions The discounted present value of future net revenues for our proved oil, gas and NGL reserves is a major component of the ceiling calculation, and represents the component that requires the most subjective judgments. Estimates of reserves are forecasts based on engineering data, projected future rates of production and the timing of future expenditures. The process of estimating oil, gas and NGL reserves requires substantial judgment, resulting in imprecise determinations, particularly for new discoveries. Different reserve engineers may make different estimates of reserve quantities based on the same data. Certain of our reserve estimates are prepared or audited by outside petroleum consultants, while other reserve estimates are prepared by our engineers. See Note 20 of the accompanying consolidated financial statements for a summary of the amount of our reserves that are prepared or audited by outside petroleum consultants. The passage of time provides more qualitative information regarding estimates of reserves, and revisions are made to prior estimates to reflect updated information. In the past five years, annual performance revisions to our reserve estimates, which have been both increases and decreases in individual years, have averaged less than 2% of the previous year’s estimate. However, there can be no assurance that more significant revisions will not be necessary in the future. If future significant revisions are necessary that reduce previously estimated reserve quantities, it could result in a full cost property writedown. In addition to the impact of the estimates of proved reserves on the calculation of the ceiling, estimates of proved reserves are also a significant component of the calculation of DD&A. While the quantities of proved reserves require substantial judgment, the associated prices of oil, gas and NGL reserves, and the applicable discount rate, that are used to calculate the discounted present value of the reserves do not require judgment. The ceiling calculation dictates that a 10% discount factor be used and that
Table of Contentsprices and costs in effect as of the last day of the period are held constant indefinitely. Therefore, the future net revenues associated with the estimated proved reserves are not based on our assessment of future prices or costs. Rather, they are based on such prices and costs in effect as of the end of each quarter when the ceiling calculation is performed. In calculating the ceiling, we adjust the end-of-period price by the effect of derivative contracts in place that qualify for hedge accounting treatment. This adjustment requires little judgment as the end-of-period price is adjusted using the contract prices for such hedges. None of our outstanding derivative contracts at December 31, 2008 qualified for hedge accounting treatment. Because the ceiling calculation dictates that prices in effect as of the last day of the applicable quarter are held constant indefinitely, and requires a 10% discount factor, the resulting value is not indicative of the true fair value of the reserves. Oil and gas prices have historically been volatile. On any particular day at the end of a quarter, prices can be either substantially higher or lower than our long-term price forecast that is a barometer for true fair value. Therefore, oil and gas property writedowns that result from applying the full cost ceiling limitation, and that are caused by fluctuations in price as opposed to reductions to the underlying quantities of reserves, should not be viewed as absolute indicators of a reduction of the ultimate value of the related reserves. Because of the volatile nature of oil and gas prices, it is not possible to predict the timing or magnitude of full cost writedowns. However, considering current and near-term estimates of oil and gas prices, such writedowns may be more likely to occur during 2009 than in recent periods. The SEC recently revised the requirement to use quarter-end prices to calculate the full cost ceiling. Beginning on December 31, 2009, the ceiling will be calculated using a 12-month average price. See “Modernization of Oil and Gas Reporting” for more information on the SEC’s revised rules. Judgments and Assumptions The discounted present value of future net revenues for our proved oil, gas and NGL reserves is a major component of the ceiling calculation, and represents the component that requires the most subjective judgments. Estimates of reserves are forecasts based on engineering data, projected future rates of production and the timing of future expenditures. The process of estimating oil, gas and NGL reserves requires substantial judgment, resulting in imprecise determinations, particularly for new discoveries. Different reserve engineers may make different estimates of reserve quantities based on the same data. Certain of our reserve estimates are prepared or audited by outside petroleum consultants, while other reserve estimates are prepared by our engineers. See Note 20 of the accompanying consolidated financial statements for a summary of the amount of our reserves that are prepared or audited by outside petroleum consultants. The passage of time provides more qualitative information regarding estimates of reserves, and revisions are made to prior estimates to reflect updated information. In the past five years, annual performance revisions to our reserve estimates, which have been both increases and decreases in individual years, have averaged less than 2% of the previous year’s estimate. However, there can be no assurance that more significant revisions will not be necessary in the future. If future significant revisions are necessary that reduce previously estimated reserve quantities, it could result in a full cost property writedown. In addition to the impact of the estimates of proved reserves on the calculation of the ceiling, estimates of proved reserves are also a significant component of the calculation of DD&A. While the quantities of proved reserves require substantial judgment, the associated prices of oil, gas and NGL reserves, and the applicable discount rate, that are used to calculate the discounted present value of the reserves do not require judgment. The ceiling calculation dictates that a 10% discount factor be used and that
Table of Contentsprices and costs in effect as of the last day of the period are held constant indefinitely. Therefore, the future net revenues associated with the estimated proved reserves are not based on our assessment of future prices or costs. Rather, they are based on such prices and costs in effect as of the end of each quarter when the ceiling calculation is performed. In calculating the ceiling, we adjust the end-of-period price by the effect of derivative contracts in place that qualify for hedge accounting treatment. This adjustment requires little judgment as the end-of-period price is adjusted using the contract prices for such hedges. None of our outstanding derivative contracts at December 31, 2008 qualified for hedge accounting treatment. Because the ceiling calculation dictates that prices in effect as of the last day of the applicable quarter are held constant indefinitely, and requires a 10% discount factor, the resulting value is not indicative of the true fair value of the reserves. Oil and gas prices have historically been volatile. On any particular day at the end of a quarter, prices can be either substantially higher or lower than our long-term price forecast that is a barometer for true fair value. Therefore, oil and gas property writedowns that result from applying the full cost ceiling limitation, and that are caused by fluctuations in price as opposed to reductions to the underlying quantities of reserves, should not be viewed as absolute indicators of a reduction of the ultimate value of the related reserves. Because of the volatile nature of oil and gas prices, it is not possible to predict the timing or magnitude of full cost writedowns. However, considering current and near-term estimates of oil and gas prices, such writedowns may be more likely to occur during 2009 than in recent periods. The SEC recently revised the requirement to use quarter-end prices to calculate the full cost ceiling. Beginning on December 31, 2009, the ceiling will be calculated using a 12-month average price. See “Modernization of Oil and Gas Reporting” for more information on the SEC’s revised rules. Judgments and Assumptions The estimates of the fair values of our derivative instruments require substantial judgment. We estimate the fair values of our oil and gas derivative financial instruments primarily by using internal discounted cash flow calculations. The most significant variable to our cash flow calculations is our estimate of future commodity prices. We base our estimate of future prices upon published forward commodity price curves such as the Inside FERC Henry Hub forward curve for gas instruments and the NYMEX West Texas Intermediate forward curve for oil instruments. Another key input to our cash flow calculations is our estimate of volatility for these forward curves, which we base primarily upon implied volatility. The resulting estimated future cash inflows or outflows over the lives of the contracts are discounted using LIBOR and money market futures rates for the first year and money market futures and swap rates thereafter. These pricing and discounting variables are sensitive to the period of the contract and market volatility as well as changes in forward prices and regional price differentials. We estimate the fair values of our interest rate swap financial instruments primarily by using internal discounted cash flow calculations based upon forward interest-rate yields. The most significant variable to our cash flow calculations is our estimate of future interest rate yields. We base our estimate of future yields upon our own internal model that utilizes forward curves such as the LIBOR or the Federal Funds Rate provided by third parties. Another key input to our cash flow calculations is our estimate of volatility for these forward yields, which we base primarily upon implied volatility. The resulting estimated future cash inflows or outflows over the lives of the contracts are discounted using LIBOR and money market futures rates for the first year and money market futures and swap rates thereafter. These yield and discounting variables are sensitive to the period of the contract and market volatility as well as changes in forward interest rate yields. From time to time, we validate our valuation techniques by comparing our internally generated fair value estimates with those obtained from contract counterparties and/or brokers. In spite of the recent turmoil in the financial markets, counterparty credit risk has not had a significant effect on our cash flow calculations and derivative valuations. This is primarily the result of two factors. First, we have mitigated our exposure to any single counterparty by contracting with numerous counterparties. Our commodity derivative contracts are held with eight separate counterparties, and our interest rate derivative contracts are held with five separate counterparties. Second, our derivative contracts generally require cash collateral to be posted if either our or the counterparty’s credit rating falls below “investment grade”. The threshold for collateral posting decreases as the debt rating falls further below investment grade. Such thresholds generally range from zero to $50 million for the majority of our contracts. As of December 31, 2008, the credit ratings of all our counterparties were investment grade. Quarterly changes in our derivative fair value estimates have only a minimal impact on our liquidity, capital resources or results of operations, as long as the derivative instruments qualify for hedge accounting treatment. Changes in the fair values of derivatives that do not qualify for hedge accounting treatment can have a significant impact on our results of operations, but generally will not impact our liquidity or capital resources. Settlements of derivative instruments, regardless of whether they qualify for hedge accounting, do have an impact on our liquidity and results of operations. Generally, if actual market prices are higher than the price of the derivative instruments, our net earnings and cash flow from operations will be lower relative to the results that would have occurred absent these instruments. The opposite is also true. Additional information regarding the effects that changes in market prices can have on our derivative financial instruments, net earnings and cash flow from operations is included in “Item 7A. Quantitative and Qualitative Disclosures about Market Risk.”
Table of ContentsJudgments and Assumptions The estimates of the fair values of our derivative instruments require substantial judgment. We estimate the fair values of our oil and gas derivative financial instruments primarily by using internal discounted cash flow calculations. The most significant variable to our cash flow calculations is our estimate of future commodity prices. We base our estimate of future prices upon published forward commodity price curves such as the Inside FERC Henry Hub forward curve for gas instruments and the NYMEX West Texas Intermediate forward curve for oil instruments. Another key input to our cash flow calculations is our estimate of volatility for these forward curves, which we base primarily upon implied volatility. The resulting estimated future cash inflows or outflows over the lives of the contracts are discounted using LIBOR and money market futures rates for the first year and money market futures and swap rates thereafter. These pricing and discounting variables are sensitive to the period of the contract and market volatility as well as changes in forward prices and regional price differentials. We estimate the fair values of our interest rate swap financial instruments primarily by using internal discounted cash flow calculations based upon forward interest-rate yields. The most significant variable to our cash flow calculations is our estimate of future interest rate yields. We base our estimate of future yields upon our own internal model that utilizes forward curves such as the LIBOR or the Federal Funds Rate provided by third parties. Another key input to our cash flow calculations is our estimate of volatility for these forward yields, which we base primarily upon implied volatility. The resulting estimated future cash inflows or outflows over the lives of the contracts are discounted using LIBOR and money market futures rates for the first year and money market futures and swap rates thereafter. These yield and discounting variables are sensitive to the period of the contract and market volatility as well as changes in forward interest rate yields. From time to time, we validate our valuation techniques by comparing our internally generated fair value estimates with those obtained from contract counterparties and/or brokers. In spite of the recent turmoil in the financial markets, counterparty credit risk has not had a significant effect on our cash flow calculations and derivative valuations. This is primarily the result of two factors. First, we have mitigated our exposure to any single counterparty by contracting with numerous counterparties. Our commodity derivative contracts are held with eight separate counterparties, and our interest rate derivative contracts are held with five separate counterparties. Second, our derivative contracts generally require cash collateral to be posted if either our or the counterparty’s credit rating falls below “investment grade”. The threshold for collateral posting decreases as the debt rating falls further below investment grade. Such thresholds generally range from zero to $50 million for the majority of our contracts. As of December 31, 2008, the credit ratings of all our counterparties were investment grade. Quarterly changes in our derivative fair value estimates have only a minimal impact on our liquidity, capital resources or results of operations, as long as the derivative instruments qualify for hedge accounting treatment. Changes in the fair values of derivatives that do not qualify for hedge accounting treatment can have a significant impact on our results of operations, but generally will not impact our liquidity or capital resources. Settlements of derivative instruments, regardless of whether they qualify for hedge accounting, do have an impact on our liquidity and results of operations. Generally, if actual market prices are higher than the price of the derivative instruments, our net earnings and cash flow from operations will be lower relative to the results that would have occurred absent these instruments. The opposite is also true. Additional information regarding the effects that changes in market prices can have on our derivative financial instruments, net earnings and cash flow from operations is included in “Item 7A. Quantitative and Qualitative Disclosures about Market Risk.”
Table of ContentsJudgments and Assumptions There are various assumptions we make in determining the fair values of an acquired company’s assets and liabilities. The most significant assumptions, and the ones requiring the most judgment, involve the estimated fair values of the oil and gas properties acquired. To determine the fair values of these properties, we prepare estimates of oil, gas and NGL reserves. These estimates are based on work performed by our engineers and that of outside consultants. The judgments associated with these estimated reserves are described earlier in this section in connection with the full cost ceiling calculation. However, there are factors involved in estimating the fair values of acquired oil, gas and NGL properties that require more judgment than that involved in the full cost ceiling calculation. As stated above, the full cost ceiling calculation applies end-of-period price and cost information to the reserves to arrive at the ceiling amount. By contrast, the fair value of reserves acquired in a business combination must be based on our estimates of future oil, gas and NGL prices. Our estimates of future prices are based on our own analysis of pricing trends. These estimates are based on current data obtained with regard to regional and worldwide supply and demand dynamics such as economic growth forecasts. They are also based on industry data regarding gas storage availability, drilling rig activity, changes in delivery capacity, trends in regional pricing differentials and other fundamental analysis. Forecasts of future prices from independent third parties are noted when we make our pricing estimates. We estimate future prices to apply to the estimated reserve quantities acquired, and estimate future operating and development costs, to arrive at estimates of future net revenues. For estimated proved reserves, the future net revenues are then discounted using a rate determined appropriate at the time of the business combination based upon our cost of capital. We also apply these same general principles to estimate the fair value of unproved properties acquired in a business combination. These unproved properties generally represent the value of probable and possible reserves. Because of their very nature, probable and possible reserve estimates are more imprecise than those of proved reserves. To compensate for the inherent risk of estimating and valuing unproved reserves, the discounted future net revenues of probable and possible reserves are reduced by what we consider to be an appropriate risk-weighting factor in each particular instance. It is common for the discounted future net revenues of probable and possible reserves to be reduced by factors ranging from 30% to 80% to arrive at what we consider to be the appropriate fair values. Generally, in our business combinations, the determination of the fair values of oil and gas properties requires much more judgment than the fair values of other assets and liabilities. The acquired companies commonly have long-term debt that we assume in the acquisition, and this debt must be recorded at the estimated fair value as if we had issued such debt. However, significant judgment on our behalf is usually not required in these situations due to the existence of comparable market values of debt issued by peer companies. Except for the 2002 acquisition of Mitchell Energy & Development Corp., our mergers and acquisitions have involved other entities whose operations were predominantly in the area of exploration, development and
Table of Contentsproduction activities related to oil and gas properties. However, in addition to exploration, development and production activities, Mitchell’s business also included substantial marketing and midstream activities. Therefore, a portion of the Mitchell purchase price was allocated to the fair value of Mitchell’s marketing and midstream facilities and equipment. This consisted primarily of natural gas processing plants and natural gas pipeline systems. The Mitchell midstream assets primarily serve gas producing properties that we also acquired from Mitchell. Therefore, certain of the assumptions regarding future operations of the gas producing properties were also integral to the value of the midstream assets. For example, future quantities of gas estimated to be processed by natural gas processing plants were based on the same estimates used to value the proved and unproved gas producing properties. Future expected prices for marketing and midstream product sales were also based on price cases consistent with those used to value the oil and gas producing assets acquired from Mitchell. Based on historical costs and known trends and commitments, we also estimated future operating and capital costs of the marketing and midstream assets to arrive at estimated future cash flows. These cash flows were discounted at rates consistent with those used to discount future net cash flows from oil and gas producing assets to arrive at our estimated fair value of the marketing and midstream facilities and equipment. In addition to the valuation methods described above, we perform other quantitative analyses to support the indicated value in any business combination. These analyses include information related to comparable companies, comparable transactions and premiums paid. In a comparable companies analysis, we review the public stock market trading multiples for selected publicly traded independent exploration and production companies with comparable financial and operating characteristics. Such characteristics are market capitalization, location of proved reserves and the characterization of those reserves that we deem to be similar to those of the party to the proposed business combination. We compare these comparable company multiples to the proposed business combination company multiples for reasonableness. In a comparable transactions analysis, we review certain acquisition multiples for selected independent exploration and production company transactions and oil and gas asset packages announced recently. We compare these comparable transaction multiples to the proposed business combination transaction multiples for reasonableness. In a premiums paid analysis, we use a sample of selected independent exploration and production company transactions in addition to selected transactions of all publicly traded companies announced recently, to review the premiums paid to the price of the target one day, one week and one month prior to the announcement of the transaction. We use this information to determine the mean and median premiums paid and compare them to the proposed business combination premium for reasonableness. While these estimates of fair value for the various assets acquired and liabilities assumed have no effect on our liquidity or capital resources, they can have an effect on the future results of operations. Generally, the higher the fair value assigned to both the oil and gas properties and non-oil and gas properties, the lower future net earnings will be as a result of higher future depreciation, depletion and amortization expense. Also, a higher fair value assigned to the oil and gas properties, based on higher future estimates of oil and gas prices, will increase the likelihood of a full cost ceiling writedown in the event that subsequent oil and gas prices drop below our price forecast that was used to originally determine fair value. A full cost ceiling writedown would have no effect on our liquidity or capital resources in that period because it is a noncash charge, but it would adversely affect results of operations. As discussed in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Capital Resources, Uses and Liquidity,” in calculating our debt-to-capitalization ratio under our credit agreement, total capitalization is adjusted to add back noncash financial writedowns such as full cost ceiling property impairments or goodwill impairments. Our estimates of reserve quantities are one of the many estimates that are involved in determining the appropriate fair value of the oil and gas properties acquired in a business combination. As previously disclosed in our discussion of the full cost ceiling calculations, during the past five years, our annual performance revisions to our reserve estimates have averaged less than 2%. As discussed in the preceding paragraphs, there
Table of Contentsare numerous estimates in addition to reserve quantity estimates that are involved in determining the fair value of oil and gas properties acquired in a business combination. The inter-relationship of these estimates makes it impractical to provide additional quantitative analyses of the effects of changes in these estimates. Judgments and Assumptions There are various assumptions we make in determining the fair values of an acquired company’s assets and liabilities. The most significant assumptions, and the ones requiring the most judgment, involve the estimated fair values of the oil and gas properties acquired. To determine the fair values of these properties, we prepare estimates of oil, gas and NGL reserves. These estimates are based on work performed by our engineers and that of outside consultants. The judgments associated with these estimated reserves are described earlier in this section in connection with the full cost ceiling calculation. However, there are factors involved in estimating the fair values of acquired oil, gas and NGL properties that require more judgment than that involved in the full cost ceiling calculation. As stated above, the full cost ceiling calculation applies end-of-period price and cost information to the reserves to arrive at the ceiling amount. By contrast, the fair value of reserves acquired in a business combination must be based on our estimates of future oil, gas and NGL prices. Our estimates of future prices are based on our own analysis of pricing trends. These estimates are based on current data obtained with regard to regional and worldwide supply and demand dynamics such as economic growth forecasts. They are also based on industry data regarding gas storage availability, drilling rig activity, changes in delivery capacity, trends in regional pricing differentials and other fundamental analysis. Forecasts of future prices from independent third parties are noted when we make our pricing estimates. We estimate future prices to apply to the estimated reserve quantities acquired, and estimate future operating and development costs, to arrive at estimates of future net revenues. For estimated proved reserves, the future net revenues are then discounted using a rate determined appropriate at the time of the business combination based upon our cost of capital. We also apply these same general principles to estimate the fair value of unproved properties acquired in a business combination. These unproved properties generally represent the value of probable and possible reserves. Because of their very nature, probable and possible reserve estimates are more imprecise than those of proved reserves. To compensate for the inherent risk of estimating and valuing unproved reserves, the discounted future net revenues of probable and possible reserves are reduced by what we consider to be an appropriate risk-weighting factor in each particular instance. It is common for the discounted future net revenues of probable and possible reserves to be reduced by factors ranging from 30% to 80% to arrive at what we consider to be the appropriate fair values. Generally, in our business combinations, the determination of the fair values of oil and gas properties requires much more judgment than the fair values of other assets and liabilities. The acquired companies commonly have long-term debt that we assume in the acquisition, and this debt must be recorded at the estimated fair value as if we had issued such debt. However, significant judgment on our behalf is usually not required in these situations due to the existence of comparable market values of debt issued by peer companies. Except for the 2002 acquisition of Mitchell Energy & Development Corp., our mergers and acquisitions have involved other entities whose operations were predominantly in the area of exploration, development and
Table of Contentsproduction activities related to oil and gas properties. However, in addition to exploration, development and production activities, Mitchell’s business also included substantial marketing and midstream activities. Therefore, a portion of the Mitchell purchase price was allocated to the fair value of Mitchell’s marketing and midstream facilities and equipment. This consisted primarily of natural gas processing plants and natural gas pipeline systems. The Mitchell midstream assets primarily serve gas producing properties that we also acquired from Mitchell. Therefore, certain of the assumptions regarding future operations of the gas producing properties were also integral to the value of the midstream assets. For example, future quantities of gas estimated to be processed by natural gas processing plants were based on the same estimates used to value the proved and unproved gas producing properties. Future expected prices for marketing and midstream product sales were also based on price cases consistent with those used to value the oil and gas producing assets acquired from Mitchell. Based on historical costs and known trends and commitments, we also estimated future operating and capital costs of the marketing and midstream assets to arrive at estimated future cash flows. These cash flows were discounted at rates consistent with those used to discount future net cash flows from oil and gas producing assets to arrive at our estimated fair value of the marketing and midstream facilities and equipment. In addition to the valuation methods described above, we perform other quantitative analyses to support the indicated value in any business combination. These analyses include information related to comparable companies, comparable transactions and premiums paid. In a comparable companies analysis, we review the public stock market trading multiples for selected publicly traded independent exploration and production companies with comparable financial and operating characteristics. Such characteristics are market capitalization, location of proved reserves and the characterization of those reserves that we deem to be similar to those of the party to the proposed business combination. We compare these comparable company multiples to the proposed business combination company multiples for reasonableness. In a comparable transactions analysis, we review certain acquisition multiples for selected independent exploration and production company transactions and oil and gas asset packages announced recently. We compare these comparable transaction multiples to the proposed business combination transaction multiples for reasonableness. In a premiums paid analysis, we use a sample of selected independent exploration and production company transactions in addition to selected transactions of all publicly traded companies announced recently, to review the premiums paid to the price of the target one day, one week and one month prior to the announcement of the transaction. We use this information to determine the mean and median premiums paid and compare them to the proposed business combination premium for reasonableness. While these estimates of fair value for the various assets acquired and liabilities assumed have no effect on our liquidity or capital resources, they can have an effect on the future results of operations. Generally, the higher the fair value assigned to both the oil and gas properties and non-oil and gas properties, the lower future net earnings will be as a result of higher future depreciation, depletion and amortization expense. Also, a higher fair value assigned to the oil and gas properties, based on higher future estimates of oil and gas prices, will increase the likelihood of a full cost ceiling writedown in the event that subsequent oil and gas prices drop below our price forecast that was used to originally determine fair value. A full cost ceiling writedown would have no effect on our liquidity or capital resources in that period because it is a noncash charge, but it would adversely affect results of operations. As discussed in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Capital Resources, Uses and Liquidity,” in calculating our debt-to-capitalization ratio under our credit agreement, total capitalization is adjusted to add back noncash financial writedowns such as full cost ceiling property impairments or goodwill impairments. Our estimates of reserve quantities are one of the many estimates that are involved in determining the appropriate fair value of the oil and gas properties acquired in a business combination. As previously disclosed in our discussion of the full cost ceiling calculations, during the past five years, our annual performance revisions to our reserve estimates have averaged less than 2%. As discussed in the preceding paragraphs, there
Table of Contentsare numerous estimates in addition to reserve quantity estimates that are involved in determining the fair value of oil and gas properties acquired in a business combination. The inter-relationship of these estimates makes it impractical to provide additional quantitative analyses of the effects of changes in these estimates. Judgments and Assumptions The annual impairment test requires us to estimate the fair values of our own assets and liabilities. Because quoted market prices are not available for Devon’s reporting units, the fair values of the reporting units are estimated in a manner similar to the process described above for a business combination. Therefore, considerable judgment similar to that described above in connection with estimating the fair value of an acquired company in a business combination is also required to assess goodwill for impairment. Generally, the higher the fair value assigned to both the oil and gas properties and non-oil and gas properties, the lower goodwill would be. A lower goodwill value decreases the likelihood of an impairment charge. However, unfavorable changes in reserves or in our price forecast would increase the likelihood of a goodwill impairment charge. A goodwill impairment charge would have no effect on liquidity or capital resources. However, it would adversely affect our results of operations in that period. Due to the inter-relationship of the various estimates involved in assessing goodwill for impairment, it is impractical to provide quantitative analyses of the effects of potential changes in these estimates, other than to note the historical average changes in our reserve estimates previously set forth. Judgments and Assumptions The annual impairment test requires us to estimate the fair values of our own assets and liabilities. Because quoted market prices are not available for Devon’s reporting units, the fair values of the reporting units are estimated in a manner similar to the process described above for a business combination. Therefore, considerable judgment similar to that described above in connection with estimating the fair value of an acquired company in a business combination is also required to assess goodwill for impairment. Generally, the higher the fair value assigned to both the oil and gas properties and non-oil and gas properties, the lower goodwill would be. A lower goodwill value decreases the likelihood of an impairment charge. However, unfavorable changes in reserves or in our price forecast would increase the likelihood of a goodwill impairment charge. A goodwill impairment charge would have no effect on liquidity or capital resources. However, it would adversely affect our results of operations in that period. Due to the inter-relationship of the various estimates involved in assessing goodwill for impairment, it is impractical to provide quantitative analyses of the effects of potential changes in these estimates, other than to note the historical average changes in our reserve estimates previously set forth. | EXCERPTS ON THIS PAGE:
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