The petroleum industry's next generation of low-hanging fruit is ripe and ready to be picked: monetizing the world's best intellectual assets.

If it isn't drilled, perforated, logged, simulated or made of cement and metal, is it of value in the exploration and production world?

Absolutely.

Dow Chemical, considered a prime mover in managing intellectual assets (IAs), has seen US $40 million in patent tax cuts and greater than $10 million in administrative cost savings since 1993. On the revenue generation side, Dow's annual licensing income increased from $25 million to more than $125 million within 3 years.

Dow managers took two critical steps to ensure success from the company's IA management program:
• set goals to triple the market value of divestitures by leveraging the IAs contributed; and
• establish measures to monitor progress (number of unused patents culled from the portfolio via tax donations, sale or other commercial means).

A multinational energy client revived a waning technology by initiating IA management. Revenues from exclusive license rights to the technology were dropping as the technology became more of a commodity. By testing the technology in various scenarios and assessing different markets, the client realized new applications with significant growth potential in the alternative automotive energy market. Subsequent due diligence provided the basis for valuing the proprietary technology using the real options incremental risk valuation method. By forming a strategic joint venture with complementary technology and distribution partners, the client is realizing the benefits of a growing commercial venture.

Why manage IA?

To extract value from registered, nonregistered and human capital IA, businesses and individuals must demand realization of value from innovation. IA management brings structure and direction to these often-neglected assets and provides premium value beyond the company's hard assets. IA management adds bottom-line value through the auditing and strategic assessment of IAs to generate revenue from licensing out, commercializing or donating underutilized IAs.

Exploration and production IA

By convention, IAs include:

• registered assets - patents, trademarks and copyrights;
• nonregistered assets - licenses, trade secrets, manuals, models, technical papers, procedures, mineral and drilling rights, leasehold interests, enhanced oil recovery techniques, technical and specialty libraries (hard copy and electronic),geological/geophysical/engineering characterization processes, proprietary drawings, software, technologies and data processing; and
• human capital - skills, experience and regional know-how about geographical regions, vendors, customers, government agencies and reservoir formations.

Registered assets are well known and easier to describe for valuation purposes. They include, for example, the ConocoPhillips patent, "Method for Gravity and Magnetic Data Inversion Using Vector and Tensor Data," which is attributable to impressive quantitative improvements to challenging deepwater areas in the Gulf of Mexico subsalt regions and the United Kingdom's Atlantic Margin lava flow regions.
Nonregistered and human capital assets are less easily understood and therefore are inherently undervalued. They include the know-how assets acquired during mergers and acquisitions, the trade secrets walking out the door when the latest early retirement package is given and the engineering processes used to develop production from the Sakhalin Islands.

When is IA management necessary?

Individuals, companies and industries that fully exploit their IA portfolios create greater returns from their portfolios. IA management often is precipitated by events that demand a complete assessment of the IA portfolio, such as mergers, acquisitions, divestitures, joint ventures and alliance formations. In addition, IA management is particularly active when competitive fields or markets change and when cost reductions are demanded.

What is the process?

Managing IA includes two main steps:

• an audit of the portfolio; and
• strategic assessment and valuation of the IAs.

The portfolio audit provides a "current state" report to management that details the audit process and results. It identifies IA families, ranks IAs based on costs and benefits, updates the company's IA policies and procedures, and identifies deficiencies along with recommendations for improvement.
The strategic assessment yields the "desired state" based on an evaluation of the IA portfolio's value relative to competitive position, market attractiveness and relationship to the overall company portfolio. An internal profile is constructed showing how the IAs relate to the company's markets, resources and capabilities. It describes premiums attributable to the IA, their useful life, any barriers that exist and the position these assets hold in the company's strategic value chain. An external profile would include competitors and peers with competing or emerging IAs, and country profiles would show where the asset portfolio has competition or opportunities.

A valuation is performed on specific IA families depending upon internal or external requirements. Key valuation parameters include the remaining useful life of the IAs and their primary measures of economic income. The valuation method options include such recognized methods as the cost, income and market plus internal valuation methods:
• relief from royalty;
• Tobin's Q; and
• tech factor.

Cost, income and market valuation

To begin with, IAs are sunk costs. They have been created and paid for by companies through their research and development efforts, acquisitions, employee salaries, process and product failures, branding and marketing campaigns and publications, to name a few. To value these IAs requires looking at the upside of how they can be commercially exploited.

Cost method

When IAs are valued, the easiest but least realistic valuation method is the cost method. Per the American Institute of Certified Public Accountants, an agency for reporting standards, the cost method summarizes sunk costs, or replacement costs, with obsolescence considerations including technological, economic and functional obsolescence.

For example, "Arctic Albert" led a research and development team to invent a reservoir process, proved in pilot field tests, based on the IA "AASimulator" to produce oil and gas simultaneously from the oil column and gas cap while injecting water at the gas-oil contact. His company has a minor interest in a joint venture in a similar multiphase reservoir where the new process would be quite beneficial. The operator is interested but will need to convince the other interest owners that it is worth the investment. Arctic Albert, his finance manager, legal beagle and joint venture manager begin assessing the valuation of the reservoir process. The AASimulator is projected to generate US $30 million in net revenues next year. (The effective income tax rate is 40%, and direct capitalization rate is 20%). They calculate a value using the research and development cost savings method: competitors' research and development expenses run 8%, Arctic Albert's average 2% for a cost savings of 6% (Table 1).

Income method

The income method is the one most often used for valuing IAs. It results in a valuation based upon the economic benefits associated with the particular IAs in question. The most common income variations employed are: discounted cash flow calculations, direct capitalization estimates, relief-from-royalty calculation, profit-split calculation, excess earnings calculation and loss of income or profits. (This latter variation is useful in acquisitions.)

For example, Arctic Albert's management isn't happy with the cost basis valuation results. The bosses' back-of-the-envelope math was closer to $8 million. Arctic Albert tries a different approach, which the operator agrees could be closer to economic truth. They agree that as licensor, Arctic Albert's company will receive 50% of the profit split with the rest of the joint venture taking the other 50%. The joint venture's operating expenses are estimated at 45% of net revenues, and selling, general and administrative expenses at 35% (Table 1).

Market method

The market approach method sometimes is called "sales comparisons." The market, the economic environment in which arm's-length transactions between unrelated parties occur, is usually the best indicator of the value of a discrete intangible asset. The market is analyzed for sales and license transactions that may be useful in the analysis of the subject discrete intangible asset. The basic elements of comparisons are legal rights; special financing terms; arm's-length sale; the guideline industry; and the functional, technological and economic characteristics of the guideline sale.

In our example example, Arctic Albert's managers are now salivating. However, they don't want to leave any money on the table when it comes to dealing with their joint venture partners. Arctic Albert is asked to go back and see what the market method might give. Using the relief-from-royalty method based on analysis of comparable license agreements in the industry, the rate selected is 5% of net revenues. Since Arctic Albert's company owns the AASimulator, it will not pay these royalties in the joint venture for the use of it (Table 1).

Arctic Albert's company decides to use the recommended IA valuation convention of weight averaging the three valuation results. Based on quality and quantity of data underlying each analysis and relevance of these factors to the AASimulator, Arctic Albert decides to assign a slight advantage (weight) to the income method.

Assessing IA management

As with hard asset management, portfolio performance is judged using a project or management scorecard. Elements of an IA scorecard may include:
• how much the portfolio increased incrementally over the prior year(s);
• goals met in strategic business plans relative to performance around the IAs;
• actions taken and economic benefits received from disposal of noncore IAs; and
• percentage of IAs cross-functionally used.

The bottom line

IA management in other industries has proven to add real dollars to companies' bottom lines. The most stunning case recently involved Forgent Networks of Austin, Texas.

Faced with a poor financial future, the chief executive officer demanded a review of the company's portfolio of 38 patents. The most promising finding was US Patent No. 4,698,672 - or the '672 patent, which covered parts of the .jpeg standard for images that is used widely in digital cameras, printers, scanners, PCs and on the Internet. Forgent obtained this patent in an earlier acquisition. Forgent's IA management program, including the auditing and strategic assessment of its IA portfolio, resulted in more than $100 million in 2002 licensing revenues attributable to the '672 patent alone. Since the patent portfolio review, the strength of Forgent's patents has helped the company achieve two profitable quarters with strong cash flow and improved working capital.

Asset management in the energy industry typically has focused on the infrastructure to explore, develop and produce hydrocarbons. With the explosion of computers, more IA value is recognized as premiums beyond the tangible assets. The energy industry, by creating IAs as problem-solving tools, contributed to this explosion. However, energy companies have been slow to capitalize on these problem-solving invisible assets. By actively managing these IAs, new revenue streams are created, old revenue streams are revitalized, operating costs are reduced, and new ventures become viable. IA management provides the tools to recognize this new generation of assets and capture additional value.