Monthly Archives: April 2017

Oil & Gas Company Valuation

 

These Oil & Gas suckers are notoriously difficult to value but can represent some of the largest gains to be had in the stock market (and some of the largest losses if you get it wrong). I therefore think it is worth the brain damage required to get my head around how this works.

The valuation of any company starts, in my view with looking at what they are selling (Quality of product and other features), how much they have to sell (Quantity of product that can be produced taking account of capacity and cost of production) and how much they can sell it for (the price in the market).

For an Oil & Gas company this breaks down to

  1. Reserves – the main question here is Quality of reserves (see below)
  2. Level of Production – how much can you get out of the ground at an economically viable cost?
  3. Selling price – which as we know is open to manipulation and fairly volatile swings

Reserves Valuation

“Quantity of energy sources estimated with reasonable certainty, from the analysis of geologic and engineering data, to be recoverable from well established or known reservoirs with the existing equipment and under the existing operating conditions. Also called measured reserves or proved energy reserves.”

Definition from the Business Dictionary

If I break down that definition a bit more we can see:

  1. estimated with reasonable certainty – bear in mind the actual product is a long way underground so no-one can go down and measure it. Geologists estimate the size of the area, but it could be as accurate as a sub-prime securitisation model if you’re unlucky
  2. to be recoverable…with the existing equipment – so i.e doesn’t require huge additional capex
  3. under the existing operating conditions. To make it clear, this means operating and economic conditions. So for example, if the oil is suddenly worth a lot less than it used to be, it may no longer be worth taking out of the ground. At this point, technically, that asset should no longer be defined as a proved reserve.

Reserves are split into categories depending upon the perceived level of comfort with the above tests. The highest quality is Proved Reserves, or P1. This is is 90% probable in the estimate of the geologist to meet the above criteria. Probable, or P2 is 50% and Possible, or P3 is 10%.

So in terms of valuation, here I have my first major problem. How can someone tell me that a 50% probabilistic reserve is worth anything, let alone a 10% probabilistic reserve? The industry recognises this and uses a 2P method (i.e. Proved and Probable – the first two above) leaving a minimum probabilistic level of 50% but on average higher than that.

This 2P figure is then taken and the Expected Monetary Value (EMV) is calculated, by taking:

probability of success multiplied by present value of excess cash flow (i.e. the profit if successful) [so basically the same as if you value some probability weighted cash flows for any business]

less

Probability of failure multiplied by any additional failure costs

Two points to note on the above:

  1. This is an estimate of the value of the reserves that is very unlikely to come to pass. It is a mathematical construct to put a definite value on what is essentially unknowable before the Oil or gas is extracted. If the company is right then the value will be the present value of the excess cash flow x 100%. If the exploration fails then the  cost will be 100% x the initial costs plus the additional failure costs. Neither of these scenarios will be near the reported balance sheet number.
  2. This is probably less important for large Oil & Gas companies, but there is a digital nature to the outcome which will greatly impact smaller companies. Success with some small variance on the size of success depending on the accuracy of the 2P figure, or complete failure, where a company has only a few sites, will have a huge impact upon the value of that company.

Production Capacity

Obviously a lot of the above is applicable to the Production process as well as the reserve value. A good Proved Reserve is worth nothing without the ability to get the stuff out of the ground. This is where I think the management of the company is key. In particular, they need to be able to, or have close connections with people who can, run the complex project management processes to efficiently extract the value, literally. Fairly unlikely that you would get a board of directors without this experience, but worth checking just in case one has slipped through the net.

Some good questions to ask at this point of the valuation:

  • Does the Board have good experience in geology? Key for assessing potential deals and partnerships on sites
  • Is there a good mix of producing sites and exploration? i.e. is the production process being managed to create a steady stream of product?
  • What is the extracted inventory?
  • Is the funding position sufficient to get the company through the current production cycle? What would the impact of a failed exploration be on that funding position?
  • Does company have a good handle on decommissioning costs? You can’t just leave an oil well or gas field when you’ve finished with it. Unlike my teenage daughter, you have to clear up after yourself.

The Market Price of Oil & Gas

Now there’s not much a company can do over the long term if Oil and Gas prices stay low, but in the short term I am looking for them to be using forward contracts to hedge expected production levels. That way there is one element of the EMV equation shown above that is certain, at least for expected production levels for a short period of time.

One question to ask here is what is cost of extraction per barrel? This allows comparison across the sector. Possibly of more relevance, it allows you to see where the pain points are for smaller companies.

You have to be careful reading too much into this though. Often small Oil & Gas companies will go into a minority partnership with larger companies. This was seen a lot in the U.S. with the fracking sites. The thing is that for example Chesapeake has a much bigger say than the Mrs Miggins Pie shop Oil Co that it might be partnering with. So when the oil price dropped in early 2016, guess what happened? The large companies decided that the margin over their cost of extraction was not that appealing and moth balled some sites. They could afford to sit on the assets for a year or two. Unfortunately for the small player, they were probably relying on their 3-5% stake in that site to keep the lights on.

So even though the small company may have a very low cost of extraction per barrel, if they aren’t in overall charge of the project, they may not get to make that decision.

Small Company warning

Most of the above goes out of the window if the company is particularly small. You don’t then have a range of exploration, production and post production sites spreading the risk. You probably have one or two. The outcome is therefore very much a big winner or a total loss. This is why you see a lot of volatility in this sector at the smaller end. It’s a bit like a Pharmaceutical company with just a few drugs. They either get approval and pass the various stages of testing, in which case they can be worth a fortune, or the company runs out of cash.

Be careful with these. The lure of going after a potential ten bagger is fine, but unless you have specific training in geology or otherwise have an edge in terms of valuing potential sites you are taking a punt. Nothing wrong with taking a few punts in a portfolio as long as you know that’s what you are doing.

I would love to hear your thoughts so please leave a comment below if you have some feedback, questions or opinions.

 

 

 

Trading Platform Review – eToro

Social Trading

eToro is a trading platform which allows traders to share their trades with others. Social Trading, as it is known, is a bit like the ADVFN Bulletin Boards but in this case you get to see if the person on the other end of the conversation is actually doing as well as they say they are.

This seems to me an inspired idea. I have to admit eToro had previously passed me by, but it opens up the whole kimono in terms of who is doing what and why. Depending upon your view regarding your skill as a trader you can either:

  1. Just trade like any other platform
  2. use some of your funds to copy other traders who have a good track record – essentially run your own fund of funds
  3. apply to be one of the traders that is followed (a “popular investor”, earning a fee depending on how much money is following you

There is a short video which explains the concept and the process takes very little time.

Concept of following (or being followed)

Following, or copying another trader has some fairly large advantages over putting your money with a professional asset manager.

  1. You know the person you are following has their own money at risk. There is no other way for them to post a trade, so you are getting a portion of what they are getting. Completely transparent.
  2. You can see a dip in performance immediately. Ever waited for a year to see your Pension Fund is suddenly worth a chunk less than the year before? Then to be faced with a once a year allocation decision? With eToro you are in control of your own money. Trade it yourself or allocate to others. If you decide there is a better option, then you can move it. Simple
  3. You get to see from their posts what the trader you are following is thinking, how they trade, what their risk appetite is. You also know their name – talk about accountability! When was the last time you met your Pension Fund Manager and were able to ask about their views?

The Concept of being a “Popular Investor”

This is potentially a great way to leverage what you are doing anyway. It’s like an asset management model, without having a five to one ratio of back office settlements, risk management, fund raisers, compliance and investor relations on the one hand, to the lonely trader on the other trying to make enough money to support them all.

You aren’t providing investment advice, you are simply trading and letting other people see your trades. In the first year of this project I made just over 25%. That wouldn’t get me anywhere near the top of this lot but it might give me a few followers, which would get me a small fee (read the details on the website here).

The Platform

Pros

Looking at the platform itself, it has a nice spread of markets and the spreads appear reasonably tight. The user interface is intuitive and clearly marks out where your stops are so there can be no confusion about how much risk you are taking on. This is important with leveraged product.

The Platform basically does what it says on the tin. CFD exposure to plenty of markets around the world.

Minimum exposure size is smaller giving less volatility. Now that can be good or bad depending upon whether you are confident as a trader. There is an option to amp up the leverage, but you can also bring it down. I like this feature as, for example, the oil market can be pretty jumpy if you are just getting to know how it works.

Talking of which, although not unique to this platform, there is a $10,000 dummy account to play with. If you aren’t familiar with the markets or CFDs but you want to give it a go, I would highly recommend playing with that for a few weeks where the only thing you can injure is your pride.

Cons

I would say the charts let it down somewhat, although there is a beta version of a much better chart package on it’s way. If you are looking for ease of reading and detail on charts however, I have to say that providers such as IG are currently better.

eToro won’t currently win any major prizes for research either, and providers such as ADVFN are still way ahead on that front.

One aspect which could be a con is that any deposits are re-denominated into USD. Be aware of this when setting your risk limits and obviously there is some currency risk that you are running if you eventually want to take out any profits in sterling, Euro or whatever else.

Conclusion

Overall, I think the social trading idea is such a good one that you can live without, or probably more likely, source the research and charts from elsewhere. This platform allows you into the world of Asset Management without the regulatory hassle, which is enormously exciting.

At the same time, if you are more of an arms length investor, it gives you the opportunity to pick your manager and allocate funds between people who you can see are doing well. Whilst I’m sure there is some form of fee or bid offer that you pay for this, it probably isn’t more than you’d pay your faceless, possibly not doing so well, Asset Manager in a more traditional institution. However, as always, make sure you read the terms and conditions so you know exactly what you are paying.

I’ve signed up under the moniker of Boman71 (apparently ISAMillionaire was already taken). So if you’re on there give me a shout – be good to hear (and see) how you’re getting on.

Click here for more details on eToro

 

 

 

 

Neil Woodford’s Patient Capital – the clue is in the name

Interesting article in the FT on Friday about Neil Woodford and his Patient Capital fund which didn’t do so well over the last year ending December 2016, posting a 4.2% loss versus a 16.8% gain for the FTSE all share index. You can read the full article here

Now Mr Woodford specialises in small cap companies. As someone who ran their own small company for 10 years, let me tell you, they are not the most predictable of beasts. However, there are certain elements to look for which should tell you whether (but not necessarily when) you have a winner:

  • Does the company have a clear offering?
  • Is the market sector they operate in growing?
  • Does the company have some form of “Moat” as Buffett would have put it. For a small company this is probably going to be in the form of intellectual property but not necessarily so – it could just be a small niche market that no-one else wants to touch
  • Are the management honest?
  • Are the management competent?
  • Are the management deluded? There is a fine line between confidence, arrogance and delusion.

On that last point, you need a confident Board, but one which is able to recognise when there are problems that need fixing in the real world where blind faith has only a limited shelf life. I spoke recently to the CEO of a peer to peer lender who proudly stated that the company had achieved a sub 0.5% loss rate on their lending over 5 years. That’s great I said, what do you think will happen over the next 5 years? The same or better came the answer.

We’ve just had a long period of historically low interest rates. My next door neighbours dog could have managed a sub 0.5% loss rate over the last five years. I would say Brexit has put an end to that cycle and interest rates will need to rise in the next year or two. At this point new borrowing will become more expensive and default rates will rise. The point is not that the increasing default rate makes this peer to peer lender a bad business, but the fact the Board aren’t preparing for it does.

At this end of the market, in my view, sniffing out this type of delusion is a critical variable in determining investment success. Whether a small cap business portfolio goes down 4.2% or up 4.2% in any given year is not relevant. Anyone who takes money out of a fund such as this on the basis of a small one year loss probably didn’t understand what they were buying in the first place.

The challenge of an investor in Neil Woodford’s fund is the same challenge as I am facing in my own investment choices, and one thing that will kill you in the markets if you lack it. Patience.

Gattaca Update – interim results

A day after the interim results, and the bid for these shares is exactly where it was for my previous post on 13th April. So no surprises, meaning the investor relations team at Gattaca did a good job in signalling where the results were likely to end up.

Looking at the results summary page, the largest driver of the lower EBITDA appears to be FX effects – primarily the falling pound post Brexit. Given that the company is looking to expand overseas revenues, they might want to look into hedging those income streams that are non-GBP denominated.

There is a webinar being hosted by the company to discuss the interim results today at 1.15pm. You can register to attend on the following link:        https://attendee.gotowebinar.com/register/7808442790992508675

UK Election – WTF?

Well, I have to admit I didn’t see that one coming. I thought given the Labour Party is in complete disarray there wouldn’t really be any need to go to the country to further enhance Teresa May’s (or Tresemme as she’s known in hairdressing circles) ability to negotiate Brexit. Sounds to me like some of the far right Tory set are getting a bit too vocal for her liking. Win the election and put them back in their box, the thinking goes.

Except, as David Cameron (you remember, the coward who spilt Brexit all over the floor and then didn’t have the Kahoona’s to stay to help clear up the mess) will tell you, sometimes you don’t win a vote that on paper you can’t lose. Sometimes you misjudge the odds and come unstuck.

From a markets perspective, a Labour Government in the UK is usually a bad thing. With Jeremy Corbyn it would be a disaster. Even fairly left leaning past leaders like Neil Kinnock are telling him it’s time to go and that he’s just not up to the job. Forget about politics a moment, if you had a business you were looking to invest in that was about to negotiate the mother of all demergers and the choice for CEO was between TreSemme and Corbyn………….

But then I also said not so long ago regarding the Brexit vote that if you have an option the value of which you don’t understand, then the only option is not to exercise it. That obviously turned out not to reflect the view of the majority in the UK.

So whilst I’m sure Teresa is sure she will win, I’m not. June 8th could be the end of my little experiment. I’m nearly a year in and returns are more or less on target. However, the final four years trying to grow my ISA at 40% with a Jeremy Corbyn Government would make a currently very difficult task look more like a psychotic episode.

I love roller coasters but I want to get off for a bit now.