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How to value E&Ps


Poor Charlie
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Hi everyone. 

I would like to begin by saying I have been following this board for some time and am very happy to be a member of your community; I just hope I will be able to contribute meaningfully while I’m here.

 

I have noticed many of the recent conversations have been about E&P companies (atpg,pbn,sd,chk).  I have no experience with E&Ps and was wondering how you all approach determining intrinsic value for these companies (FCF,BV,PV-10,M&A??).  Even at $90/bbl many E&Ps have low (no) earnings, outspend cash flow, and have little/negative book values.  Is this a distortion due to the accounting methods (full cost) or are E&Ps really doing this poorly?  According to the company presentations new wells are generating great roic (+50%), why is this not reflected in the #’s?

 

Thanks for any responses!

Poor Charlie

 

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Welcome Charlie.

 

Here are my thoughts - http://cornerofberkshireandfairfax.ca/forum/index.php?topic=3338.0

 

Here are Ken Peaks - http://www.contango.com/investor/events/E_P_101_The%20Short%20Course.ppt

 

If you are short on time, focus on Mr Peaks thoughts. The man knows what he is doing. Feel free to ask any additional questions.

 

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Its all about assets and cash flow with E&P companies. You are also basically inmo making a directional bet on the commodity when you invest. ATPG, SD, and CHK are cheap because they have great assets, but dont generate significant cash flow given there leverage. We are all betting that oil prices increase, gas prices rebound, or / and they have hit a turning point where cash flow covers capex and interest charges. Then they can drill and continue to grow production, while servicing debt. Its a tough bet, to make but looks good inmo.

 

Rising prices for me are a bonus, and hedges help with falling prices. The stocks are akin to buying a company in a loss position that is about to start generating massive cash flow. If you are correct you win big. XOM, is akin to buying something at 4x CF and hoping it gets revalued to 5 - 6 or that oil prices continue to raise.

 

You will do well, but inmo wont make any real money.

 

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Also to be quite Frank. The raise in oil and gas prices scares the hell out of me. Oil is an interesting commodity - when food prices rise people starve, but if oil spikes too much it can kill the economic recover by consuming too much of everyones income (oil is embedded in everything). I also dont like the bullishness on oil. If you do invest I would focus on companies which do just fine at $70 - $80 oil.

 

I would be looking to get out of oil right now or close to $100, but SD and ATPG are doing some very interesting things. With regard to gas, I think value investors love to be contarian, but in my opinion we have a fundamental shift and not so much a typical commodity cycle.

 

Those are my 2 cents, and they could be overvalued.

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... With regard to gas, I think value investors love to be contarian, but in my opinion we have a fundamental shift and not so much a typical commodity cycle.

Myth - what do you make of those who claim that the new gas supplies (based on frac) deplete very fast, for example 50% over the first year or two, and that ultimately their cost of extraction per energy recovered is much greater than is currently being estimated?  I have read many suggestions that nat. gas prices are likely to stay low because of the fundamental changes in extraction methods, but not everyone seems to agree.    As a contrarian, I tend to give some credibility to those with the minority opinion ... but this seems pure speculation as well.

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I think its a valid point, but the world is awash in gas. Shale is popping up in several places, and between the US and Canada North America has too much gas in the ground. People can play the game hoping the stuff being produced runs out due to declines, but I dont like that game. I dont see discipline among producers, and alot of the oil plays produce some residual gas. I also dont see gas usage expanding anytime soon due to infrastructure issues.

 

Commodities are already really crappy businesses. I dont want to buy ones that I am personally bearish on, which appear to be oversupplied. Its below the cost of production, but some of the producers dont seem to care. Everyone is hoping someone else stops drilling. Hell half the producers produce oil as well and can afford a loss on gas. They are starting to respond now, but I think they will come back in full force with any sign of a recover.

 

Im a peak cheap oil guy. I would rather own something that is in high demand, has no reasonable substitutes, is traded world wide, and is running out (at least the easy to find cheap stuff). I buy based on $65 - $75 oil and dont have to make any major assumptions on the price movements. Its going higher due to supply and demand, world economic recovery / growth, 2.3 billion people in the third world clammering for a second world / first world lifestyle, and inflation / QE2.

 

If its cheap on $70 oil, and oil is going up then I just buy and wait. SD and ATPG would mint money on $70 oil, $90 - $100 oil is just icing. Gas is in the too hard pile, for me. There will be a spike, I will make money because SD and ATPG will hedge the hell out of gas. Aside from that I am fine. Im not going to buy a company that will be dead in the water should gas prices not move back up soon (Compton or so).

 

My friend is contarian. He invested in Circuit City and is still doubling down on Irish Banks. Sometimes when there is smoke, something is on fire. Is it a paradigm shift, or a just part of the cycle. I dont know and wont find out with my capital. Also we just had the worst winter possible in terms of snow storms. Gas is still under $5. 2008, 2009, 2010 were some of the hottest years ever recorded. Mother nature is doing her part, we just have too much gas.

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Myth - thanks for the details.  Hard to counter-argue.   So then the old metric of about 6 to 1 (oil to gas for equivalent heating value) is out the window ... is there a new "norm" for that ratio?

 

You cant argue with science and thats science. The issue is cars and planes dont run on nat gas and the infrastructure for both are no where near the same. Nat gas isnt even trade-able on the world stage (outside of LNG). The energy equivalent is 6 to 1 but I dont think the value will ever hit that unless you make nat gas and oil interchangeable. That will require massive infrastructure investments.

 

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Also dont get me wrong someone will make a killing on gas at some point, just like someone made a killing on uranium, or rare earths. They will simply be much smarter or luckier then me LOL. Its in my too hard pile, but that has more to do with me than gas.

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Myth, thanks for the response.  The Ken Peaks link was very helpful.  I remember reading somewhere that in his divorce he let his ex have his ongoing salary in exchange for not giving up any equity.  Must really believe in Contango.

 

A few more basic questions on E&Ps:

 

-What does a typical well decline curve look like?  SDs Midcontinent wells come online at around 300boepd, peak at around initial production, and produce 300-500mboe total.  Are these results comparable to other onshore U.S. (Permian,Bakken,etc)?  Also how long does a typical well produce?  Read that Permian legacy assets have +30 years of production potential while as Roundball mentioned frac is very short. 

 

-How economic is tertiary oil recovery (CO2,water,well downspacing)?  OXY has had very good success with these but don’t hear much from anyone else.  Do they have the same potential as frac’ing to increase oil production?

 

-When Tom Ward and others talk about 50% RoR in the Permian and +100% RoR in Midcontinent are they referring to the entire life of the well?

 

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Myth, thanks for the response.  The Ken Peaks link was very helpful.  I remember reading somewhere that in his divorce he let his ex have his ongoing salary in exchange for not giving up any equity.  Must really believe in Contango.

 

A few more basic questions on E&Ps:

 

1. -What does a typical well decline curve look like?  SDs Midcontinent wells come online at around 300boepd, peak at around initial production, and produce 300-500mboe total.  Are these results comparable to other onshore U.S. (Permian,Bakken,etc)?  Also how long does a typical well produce?  Read that Permian legacy assets have +30 years of production potential while as Roundball mentioned frac is very short.  

 

2. -How economic is tertiary oil recovery (CO2,water,well downspacing)?  OXY has had very good success with these but don’t hear much from anyone else.  Do they have the same potential as frac’ing to increase oil production?

 

3. -When Tom Ward and others talk about 50% RoR in the Permian and +100% RoR in Midcontinent are they referring to the entire life of the well?

 

 

I will answer these as best I can but these are pretty technical.

 

1. I know as much about well declines as you  :). Fracked wells produce at high rates then decline rapidly - think 50%, 25%, 20%, 15%, 10%, 5% and so on (I made these numbers up but something like that, its an exponential decline which looks like a bell curve). Regular wells produce at decent rates, but still feature declines (though at lower rates). I owned MLPs and they focus on mature wells. A well decline rate (either fracked or regular) declines overtime as the well matures. Probably has to do with pressure, as pressure declines so does production levels. At some point you get a well which produces (relative to initial production) very little but declines at 3%. I think Frack wells will produce for a long time, once all of the declines happen but am not sure. Also you may have to resort to secondary and tertiary recovery methods, but I believe you can have long term production from these wells. These are great assets inmo because you dont have to pump so much into drilling to keep production flat. Its why MLPs focused on them.

 

I like to know where the company is in terms of production. New wells, Medium, or Mature. After that I am good to go. I know CHK and SD have to pump a decent amount of capital into new wells to maintain production. So whatever cash they throw of is not truly free. Something like BBEP doesnt have to because they have more mature wells. Knowing what type of player I am dealing with helps when looking at Maintenance capex. I dont get too deep though, pretty much stay high level here and have picked up what I know from owning different players over the last 3-4 years.

 

Honestly this stuff is what Tom Ward is paid for (and man is he well paid). I keep up with the basics, and let them worry about this.

 

http://www.theoildrum.com/node/5868

 

2. I owned REN options. I sold them and missed out on 50% - 100% gains. They focused on CO2 EOR. I think its quite economic if one can get access to cheap CO2. http://www.resolutenaturalresources.com/downloads/ResoluteInv%201%204%2011%20Final.pdf

 

I dont worry about which method has more potential. At the end of the day  I wont to know if you have the assets, and do you have a way to turn them into cash flow. REN had a good idea. I just thought CEN, SD, ATPG would work out better. I was right. But Cheap Warrants are Cheap Warrants and they would have delivered a great return. REN has cheap CO2, I like the Plant deal for SD, not sure how it works out for OXY but it is probably cost effective. Hopefully it works out for them, though I havent really looked into them at all.

 

3. I think its over the life of the well. I dont really pay much attention to the ROR. I think its a flawed calculation, but it works surprisingly well in Oil and Gas. What I am concerned with is payback. If the well pays for itself in the first year I am happy. Even if decline rates are 50%, I get half that production for free, I have already gotten my capital back. Thats how I look at it. At some point you will have a bunch of mature wells, with low decline rates for free / zero basis. If you think oil prices are going higher then thats even better.

 

SD is an interesting company. Its similar to XEC, all cash flow and debt is reinvested in drilling. Its the first investment I have made where cash flow kinda sucks and you are basically betting on increased drilling success and eventually oil and gas prices. CEN is the type of oil and gas play I have typically invested in. It was trading at 2x CF and had decent production coming online. Typically oil and gas stocks trade at 4-5 CF.

 

 

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I stay big picture. Cash Flow, Assets, and future prospects for both. Focus on cash flow first, near term production and prospects next, thoughts on the commodity, and finally reserves / assets.  - Very similar to Eric Nuttall who has a series of interviews on BNN ( See Petro Bakken thread). Most other details I learn as I go. Alot of quarterly calls and investor presentations primarily on the companies I own or follow.

 

Currently I am getting a first rate lesson from Tom Ward in resource conversion.

ATPs management is giving me a first rate lesson on deep water drilling, safe operations, and effective lobbying.

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Myth, thanks for posting the slides.  I find SD to be a very interesting company and would love to know the logic behind Watsa’s purchase.

 

I am curious as to what some of you think the likelihood of an SD buyout is.  The Century Plant would put OXY near the top of the list inmo.

 

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I dont think its too high, Ward seems like he likes control and has backing from FFH. At the right price anything is possible. I dont see him taking a buyout for less than $17 a share. Most of his shares are  underwater. I think a sale may happen, but they will prove up the Miss play first and may wait for a rebound in Nat gas. Right now you would be selling when 1 asset is still being proved up and another is severally depressed.

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For what it's worth, I believe going long a leveraged natural gas producer like Compton Petroleum (Toronto: CMT; C$0.40 per share) is incredibly compelling. With Compton, shareholders can win simply from asset sales even in a low natural gas environment. But natural gas prices won't stay low -- it just doesn't compute that the same amount of energy would cost you $25 with natural gas versus $90 with oil.  This gap will close, and some of it will occur due to higher natural gas prices.  In a couple of years, it will seem obvious that nat gas prices had to go higher, but right now it's easy to fall for the analyst consensus.  Think about it this way: If nat gas can make one boe cost $25 into perpetuity no matter the inevitable increase in demand, the world's -- or certainly North America's -- energy problems will be solved.  Do you really think this will happen?  I don't think so, but if it does, I'll be happy to lose my shirt in Compton (though Compton has value even at current nat gas prices).  I own a lot of Compton, but don't take this as a recommendation to buy, and please do your own work.

 

As an aside, over on the Fibrek board, people are now showing articles about how China will use more toilet paper and how this will make pulp a hot commodity.  I remember less than two years ago, in the summer of 2009, many folks saying that pulp was a terrible commodity and that Fibrek was doomed (it traded at C$0.20 then).  I still own Fibrek, but I certainly have no illusions about pulp.  If the choice is pulp or natural gas, I choose the latter.

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http://www.cnbc.com/id/41058387

 

Investor RCH energy says that NG prices will probably be low for a while due to  disruptive technologies. He talks about valuations--he says that you used to used to value on reserves and land, but now that does not matter as much as cash flow + return on investment.

 

I think you should find low cost producer making money today at a current price of NG, with a decent return on investment, while getting reserves at a discount.

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I have stated my thoughts on Nat gas. Eric Nuttell a guy who works with Sprott also thinks Compton is a dog. I havent really looked at it in detail but I would prefer less leverage in gas. Looking at things on a BTU basis is interesting, but you have to consider the infrastructure and uses available. I dont know how many cars are in the US but very few of them can run on CNG. The pricing would close naturally if we could all switch but planes, and cars in service are stuck with oil based engines.

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Myth,

 

Pickens is pushing for long-haul trucks to convert first. If that happens you may see a changeover begin as the infrastructure is slowly put in place. It makes sense from a balance of payment & security of supply point of view as well but it would be expensive and time consuming to convert cars....

 

cheers

Zorro

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Eric Nuttell a guy who works with Sprott also thinks Compton is a dog.

 

I'm happy to be the idiot on Compton for a while, just hopefully not forever!  I have been loading up on Compton around C$0.40 per share.  It looks like Peter Seldin's Centennial Energy has been dumping on me, so your friend Eric Nuttell is not the only one who thinks Compton sucks.  I am scared but also kind of excited that these guys who know much more about E&P investments are on the other side of Compton.  Sometimes the industry specialists are the ones who miss the easy pickings because they are too focused on the best-of-breed companies in their industry.  The great -- or terrible -- thing is that time will definitely be the judge, so we'll see what happens.  That's what I love about investing -- there is a scorecard and no place to hide.

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Pickens plan seems to make sense. Install NG infrastructure + Convert all government fleets, large fleets of truck...is there not something you can install on a normal car to covert to NG??

 

Why would you not want to do this if you re operating a large fleet of vehicles? That would be a significant savings on fuel costs

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manualofideas, I share your view of Compton.  Their appears to be a good amount of asset value covering you at the current stock price, but I do fear liquidity after 12 months absent higher gas prices.  As such, I'm considering purchasing some Compton bonds in the low to mid 80s and allocating my expected interest payments to purchase equity.  If liquidity does turn out to be an issue, the bonds will likely be the fulcrum security in a reorganization and the interest I've received will pay the cost of my presumably worthless equity. Just a thought.

 

 

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Pick your time horizon (in years) - & the commodity. Yes, NA is awash in gas (short-term), but not so much in the medium to long-term. Were that not the case, the McKenzie Valley pipeline would not be going ahead.

 

Pick your sector, & know how it works. Land or off-shore? Specific oil/gas field? Operator, distributor (wholesale, retail, futures trader), or servicer? (drilling, transportation, catering, shelter). What are the production methods, depletion rates, etc?.

 

Define your expectation. What needs to happen to get there, what you think the odds are on it occurring. Double, or triple? Sell assets, or drill for it? Buy someone else & hold for gas price increases? Operational efficiencies? 

 

Very basic research before you even enter the sector.

 

SD

 

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Pickens plan seems to make sense. Install NG infrastructure + Convert all government fleets, large fleets of truck...is there not something you can install on a normal car to covert to NG??

 

Why would you not want to do this if you re operating a large fleet of vehicles? That would be a significant savings on fuel costs

 

I thought the same, the issue though is delivering gas around the US in the proper format. There is also a problem in getting the CNG to the fueling stations and getting fueling stations with the right infrastructure. The University Economist / Energy Executive said that there was only 1 public CNG fueling pump in all of Houston.

 

From what I heard that day, its a massive under taking which would require billions in infrastructure (new pipelines, plants, and stations). It pretty much requires some sort of centrally lead plan. It may happen but it will take years.

 

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Manual you may be right in the end. We know gas has to move up to the marginal cost of production and thats around $5 - $7 dollars. Something will get us there at some point and money will be made on gas. I think its going to be in the dog house for a year or two, but natural gas has a habit of making a fool out of predictors. Its too hard for me but I wish you luck. I would rather play oil and get a call option on gas.

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