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
- Reserves – the main question here is Quality of reserves (see below)
- Level of Production – how much can you get out of the ground at an economically viable cost?
- Selling price – which as we know is open to manipulation and fairly volatile swings
“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.”
If I break down that definition a bit more we can see:
- 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
- to be recoverable…with the existing equipment – so i.e doesn’t require huge additional capex
- 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]
Probability of failure multiplied by any additional failure costs
Two points to note on the above:
- 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.
- 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.
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.