How do you value an E&P company?

[muscleman]

There are some popular E&P stocks in our investment ideas section, but I am not sure what the best way it is to do valuation on these names?

Do we just look at the PV-10, or the NAV?

[ItsAValueTrap]

You can try to figure out the market value of all their assets.  It's related to the PV-10 value of their reserves.

 

However... I think that most oil and gas companies inflate the value of their reserves.  This is more likely if they are constantly issuing stock.

 

2- When oil and gas companies sell their assets, they will often open up a data room so that buyers can do due diligence.  I'm not happy that I cannot do the same level of due diligence (and I don't have the expertise to do it anyways)... so most of these companies will fall into the "too hard" category.

 

It might be ok to go long the companies with honest & good management.  (That means no dishonest CEOs like the ones at Chesapeake, Sandridge, ATPG, etc.)

 

In some cases a company might sell off a portion of its assets, so you can infer a value about the rest of the assets.

[muscleman]

You can try to figure out the market value of all their assets.  It's related to the PV-10 value of their reserves.

 

However... I think that most oil and gas companies inflate the value of their reserves.  This is more likely if they are constantly issuing stock.

 

2- When oil and gas companies sell their assets, they will often open up a data room so that buyers can do due diligence.  I'm not happy that I cannot do the same level of due diligence (and I don't have the expertise to do it anyways)... so most of these companies will fall into the "too hard" category.

 

It might be ok to go long the companies with honest & good management.  (That means no dishonest CEOs like the ones at Chesapeake, Sandridge, ATPG, etc.)

 

In some cases a company might sell off a portion of its assets, so you can infer a value about the rest of the assets.

 

Thank you! So the primary issue is how to get an accurate PV-10 value then?

[ItsAValueTrap]

Well of course there are ways to inflate/deflate the PV-10 value.

 

Even Contango Oil & Gas under Ken Peak had to restate their reserves (downwards).

[muscleman]

Well of course there are ways to inflate/deflate the PV-10 value.

 

Even Contango Oil & Gas under Ken Peak had to restate their reserves (downwards).

 

So even for super investors like Carl Icahn, he could not take a look at the detailed data room in CHK before he decides to attack McClendon?

[kevin4u2]

Well of course there are ways to inflate/deflate the PV-10 value.

 

Even Contango Oil & Gas under Ken Peak had to restate their reserves (downwards).

 

What are the ways to inflate/deflate PV-10?  Are you saying that independent reserve evaluators are paid off to inflate reserves? 

 

Why did contango have to restate their reserves?  I am not familiar with this situation but often it is require because of technical or economic reasons but not from fudging the reserves.

[ItsAValueTrap]

What are the ways to inflate/deflate PV-10?

Why not Google "oil and gas reserve estimation" and come to your own conclusions?

 

Or try this Wikipedia page for a start:

https://en.wikipedia.org/wiki/Oil_reserves

 

Are you saying that independent reserve evaluators are paid off to inflate reserves? 

Management teams can:

1- Hire only engineers that are extremely optimistic.

2- Pressure the engineers to deliver a high number.

 

I don't think that they pay them off to inflate reserves.  It's not bribery but the effect is the same.

 

Why did contango have to restate their reserves?

It's because reserve estimation is inherently uncertain.  You might get a lot more or a lot less oil/gas than you initially expected.

 

It's really hard (or impossible) to differentiate between honest mistakes and dishonest estimations.  A side effect of this is that it is almost impossible to prove fraud.  This means that there will be few repercussions for inflating reserves.

[nsa122]

My admittedly fledgling attempts at valuing these companies are flummoxed by this industry's capital expenditures. Individual firms' capital expenditures are frequently higher than the operating cash flow, or even in some cases, revenue.  Even for instance Devon ($24B), has had a net negative free cash flow over the past 10 years (2003-12) (-1.3B per Morningstar). And this is in a decade of some of the highest prices ever.  How would anyone value this company, unless you had a crystal ball for energy prices over the next 15 years? This to me destroys any hopes of evaluating these companies on some sort of "value" basis. If they hit a big find, they just double down and place even larger bets on stable/rising prices.  These companies managements' are apparently either overconfident in their prediction of petroleum prices or don't particularly care about shareholder return, rather building their own fame and fortune, as evidenced most glaringly by CHK, SD.  I suspect a combination of the two.  I marvel at XOM's remarkably consistent record of reducing share count and increasing dividends. Their capital expenditures are much smaller (relatively speaking), and I suspect that they get the pick of the litter in terms of acquiring assets from overextended firms when prices drop.  Would be happy to hear someone with a conflicting view.

[kevin4u2]

What are the ways to inflate/deflate PV-10?

Why not Google "oil and gas reserve estimation" and come to your own conclusions?

 

Or try this Wikipedia page for a start:

https://en.wikipedia.org/wiki/Oil_reserves

 

I am very aware of how oil and gas reserves are estimated.  Having worked in the industry I hear these comments all the time but rarely do most investors understand the dynamics at play. 

 

I was interested in how you believe they inflate reserves because you made the statement. 

 

The problem with PV-10 estimates is that nobody uses them although they are often the best engineering estimate of the reserve value based on current prices (if evaluated by an independent firm).  As the other poster said the issues is with the price deck used in the PV-10 calculations.  That is impossible to estimate. 

[muscleman]

What are the ways to inflate/deflate PV-10?

Why not Google "oil and gas reserve estimation" and come to your own conclusions?

 

Or try this Wikipedia page for a start:

https://en.wikipedia.org/wiki/Oil_reserves

 

Are you saying that independent reserve evaluators are paid off to inflate reserves? 

Management teams can:

1- Hire only engineers that are extremely optimistic.

2- Pressure the engineers to deliver a high number.

 

I don't think that they pay them off to inflate reserves.  It's not bribery but the effect is the same.

 

Why did contango have to restate their reserves?

It's because reserve estimation is inherently uncertain.  You might get a lot more or a lot less oil/gas than you initially expected.

 

It's really hard (or impossible) to differentiate between honest mistakes and dishonest estimations.  A side effect of this is that it is almost impossible to prove fraud.  This means that there will be few repercussions for inflating reserves.

 

If this is so difficult to do, why do we still see super investors buying E&P names? Do they have any special edge in it?

[JSArbitrage]

These companies managements' are apparently either overconfident in their prediction of petroleum prices or don't particularly care about shareholder return, rather building their own fame and fortune, as evidenced most glaringly by CHK, SD.

 

I think this is simply a result of the nature of E&P: you are always buying depleting assets.  This isn't like Coca-Cola where you can be reasonably certain there will be more servings 10 years from now than today without much effort from Management.  The only way for an E&P company to sell more servings is to buy more assets or explore for more assets. 

 

Secondly, when it comes to reserve adjustments, you have to understand how PV10's are created.  There is really no such thing as purely proved, probable or possible reserves.  Reserves are defined using SEC (previous 12 month) pricing as an indicator of the "economic environment."  So you can have a reserves that are proved reserves at some level of commodity prices and probable reserves at some other level of pricing.

 

If you've ever tinkered on ARIES or some other similar reserve engineering software, you can see that there are 100 levers that can be pulled to change volumetrics, reserve classification, reserve values, etc.

 

One rule of thumb to keep in mind is that any acquiror that buys reserves and books goodwill as a result are massively overpaying.  Most major accounting firms have the idea that there is almost never goodwill in an E&P acquisition.  They will pull every lever they can possibly pull (within the bounds of reason) to eliminate goodwill.  So you know if an E&P company is repeatedly doing deals with goodwill, they are paying huge premiums and will probably have a write-down sooner or later.

[nsa122]

In response to the original question, I would suggest that if you want to be repaid in dollars (as opposed to dividends of oil or gas), and view the shares as part of a money-making machine, then EV/FCF, projected FCF growth, and return on invested capital should be primary metrics, regardless of the industry.  The reserves and production are intermediate steps that may or may not eventually yield cash return.

 

[nsa122]

Comparing XOM and DVN further just for learning purposes. 

 

XOM

2013 EV $408B

10yr capex $237B

10yr dividends $90B

10yr FCF $263B

10 year returns w/reinvested dividends--12%

20 year returns w/reinvested dividents--12%

Dividend yield 2.6%

PE ~10

 

DVN

2013 EV $35B

10yr capex $58B

10yr dividends $2B

10yr FCF $-1.2B

10 year annualized return w/reinvested dividends--9%

20 year annualized return w/reinvested dividends--9.7%

Dividend yield 1.35%

PE ~13

 

So far, doesn't appear that DVN's cap ex has been well spent.

I'd suggest that XOM is the BRK of the oil and gas industry in terms of capital allocation. If you look at total return calculator for the past 20 years (dividend reinvestment for XOM), BRK and XOM are neck and neck, despite XOM being much larger in 1993.

Given the above, would anyone opt for DVN over XOM at current valuation? Or care to propose a company in the industry that is a better value than XOM?

[SharperDingaan]

Take a page from portfolio management; 90% of your return will come from asset and sector allocation (correctly timing the cycle), with only 10% from the name itself. Focusing on Coy X, versus Coy Y, is not really productive.

 

Quality matters. Coy Z may cost more; but they are going to be doing the consolidating if the sector is really as undervalued as you think it is, and they know their business a lot better than you do. Do you want to be with the experts, or do you feel really lucky.

 

Time and high cap costs are your friends. Once your costs are fixed, every inflation uptick makes new plant less likely, & small tech improvements can easily bump throughput up 50%+; & dramatically lower BE.

 

Not very sexy, but way more reliable.

 

[muscleman]

Comparing XOM and DVN further just for learning purposes. 

 

XOM

2013 EV $408B

10yr capex $237B

10yr dividends $90B

10yr FCF $263B

10 year returns w/reinvested dividends--12%

20 year returns w/reinvested dividents--12%

Dividend yield 2.6%

PE ~10

 

DVN

2013 EV $35B

10yr capex $58B

10yr dividends $2B

10yr FCF $-1.2B

10 year annualized return w/reinvested dividends--9%

20 year annualized return w/reinvested dividends--9.7%

Dividend yield 1.35%

PE ~13

 

So far, doesn't appear that DVN's cap ex has been well spent.

I'd suggest that XOM is the BRK of the oil and gas industry in terms of capital allocation. If you look at total return calculator for the past 20 years (dividend reinvestment for XOM), BRK and XOM are neck and neck, despite XOM being much larger in 1993.

Given the above, would anyone opt for DVN over XOM at current valuation? Or care to propose a company in the industry that is a better value than XOM?

 

I think it depends on per well IRR.

If the per well IRR is very good, then it makes sense to use all the FCF to grow the business.

In case of DVN, I am not very familiar with it, but if it can make 50% IRR, why not use all the FCF to drill and grow?

[nsa122]

Per well IRR would be great if you had all the necessary data/evidence to independently do the calculations yourself and the decision making power on what to do with the wells' cash flow. But unfortunately, you are stuck putting your faith in a management that usually is heavily biased in favor of drilling more wells as an institutional imperative, and you are along for the ride.  I think the long term analysis of value created by say, 10 years of cap ex is a useful metric to tell how much stock to put in extravagant claims of IRRs. If capex has not yielded shareholder wealth (eg DVN), then the reliability of projected well IRRs seems dubious.  I imagine all these natural gas wells had fabulous IRRs until the bottom dropped out of the price, which to me is the reason not to reinvest all FCF into more drilling (unless you want to hedge/lock in prices for the life of the well, which I haven't heard of anyone doing, please correct me if I'm wrong).   

[kevin4u2]

 

I think it depends on per well IRR.

If the per well IRR is very good, then it makes sense to use all the FCF to grow the business.

In case of DVN, I am not very familiar with it, but if it can make 50% IRR, why not use all the FCF to drill and grow?

 

Have you ever attended an industry oil and gas conference where every single company can drill 100% IRR wells?  If you haven't go attend one. 

 

The problem with all the promotional crap in the oil and gas industry is that it is exactly that, crap.  If you don't believe me, I urge you to show me a company with 50% IRR's that also has 50% return on capital coming out the back end of the company, that being the financial statements.  Not going to find it.  50% IRR = smoke and mirrors. 

[kevin4u2]

 

One rule of thumb to keep in mind is that any acquiror that buys reserves and books goodwill as a result are massively overpaying.  Most major accounting firms have the idea that there is almost never goodwill in an E&P acquisition.  They will pull every lever they can possibly pull (within the bounds of reason) to eliminate goodwill.  So you know if an E&P company is repeatedly doing deals with goodwill, they are paying huge premiums and will probably have a write-down sooner or later.

 

Your rule of thumb is not true.  If a company can buy another that has reserves worth $1 billion but only paid $500 million to develop those reserves will be worth more than the value on the books, period.  The problem is rarely does many oil and gas firms earn high returns on capital to generate goodwill. 

 

Secondly, if one company can acquire another one for book value and then shortly there after commodity prices fall say in half, the acquirer will have to write down the acquisition, period.  Book value has no meaning.  In other words, once the costs have been spent, the value of the oil or gas asset is purely a function of prices times expected production (which is a function of reserves). 

 

I can also say this from experience, because as an investor I have only invested in one oil and gas firm and have always pay more than book value, so I as an investor am paying up for "investor goodwill".  Why is that?  Because over the full cycle the company I have invested in has generated about $2.5 in asset value for every $1 in capital spent. 

 

As the other poster said, return on capital is return on capital, regardless of the industry.  Oil and gas included. 

[ItsAValueTrap]

The problem with PV-10 estimates is that nobody uses them although they are often the best engineering estimate of the reserve value based on current prices (if evaluated by an independent firm).  As the other poster said the issues is with the price deck used in the PV-10 calculations.  That is impossible to estimate. 

 

Are you saying that you would trust PV-10 estimates?

 

My problem with the oil & gas industry is that I don't trust them.  They can distort the economics of their wells with few repercussions.  This is a recipe for disaster.  Rampant lying in the industry with few repercussions for lying is a recipe for disaster.  This is how I see the majority of independent oil and gas companies out there (and junior miners, chinese reverse mergers, etc.).  It will end badly.

 

I can also say this from experience, because as an investor I have only invested in one oil and gas firm and have always pay more than book value

What does book value have to do with anything?

 

Full cost versus successful efforts accounting will yield different book values for the same company.

 

If this is so difficult to do, why do we still see super investors buying E&P names? Do they have any special edge in it?

I'm starting to think that they are buying things outside their circle of competence.

 

 

Buffett's style is to do business with people with integrity.  So if the management team is honest, then you can probably trust their resource/reserve estimates.  He has invested in oil&gas for a long time... Exxon, PetroChina, Conoco Philips, etc.  I don't think he ever got burned with reserves or economics being overstated.  Munger or Buffett has made some kind of comment about being bad at judging resources/reserves (and technology).

In hindsight, his forays into commodities don't seem to have been as brilliant as his other moves.  He hoarded physical silver, invested in Cliffs a long time ago, etc. etc.  I think that Buffett is on another level compared to other investment managers out there.  It's just that it's hard to get crazy returns out of some commodity industries.  Here's what he said in his 1989 letter:

 

    I could give you other personal examples of "bargain-purchase" folly but I'm sure you get the picture:  It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.

[muscleman]

The problem with PV-10 estimates is that nobody uses them although they are often the best engineering estimate of the reserve value based on current prices (if evaluated by an independent firm).  As the other poster said the issues is with the price deck used in the PV-10 calculations.  That is impossible to estimate. 

 

Are you saying that you would trust PV-10 estimates?

 

My problem with the oil & gas industry is that I don't trust them.  They can distort the economics of their wells with few repercussions.  This is a recipe for disaster.  Rampant lying in the industry with few repercussions for lying is a recipe for disaster.  This is how I see the majority of independent oil and gas companies out there (and junior miners, chinese reverse mergers, etc.).  It will end badly.

 

I can also say this from experience, because as an investor I have only invested in one oil and gas firm and have always pay more than book value

What does book value have to do with anything?

 

Full cost versus successful efforts accounting will yield different book values for the same company.

 

If this is so difficult to do, why do we still see super investors buying E&P names? Do they have any special edge in it?

I'm starting to think that they are buying things outside their circle of competence.

 

 

Buffett's style is to do business with people with integrity.  So if the management team is honest, then you can probably trust their resource/reserve estimates.  He has invested in oil&gas for a long time... Exxon, PetroChina, Conoco Philips, etc.  I don't think he ever got burned with reserves or economics being overstated.  Munger or Buffett has made some kind of comment about being bad at judging resources/reserves (and technology).

In hindsight, his forays into commodities don't seem to have been as brilliant as his other moves.  He hoarded physical silver, invested in Cliffs a long time ago, etc. etc.  I think that Buffett is on another level compared to other investment managers out there.  It's just that it's hard to get crazy returns out of some commodity industries.  Here's what he said in his 1989 letter:

 

    I could give you other personal examples of "bargain-purchase" folly but I'm sure you get the picture:  It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.

 

Thank you!

So when you say independent oil and gas companies, do you mean the junior ones, or even the major ones including BP and Exon?

I now at least understand why it will be better to buy Exon than DVN, as posted by the other member here. These big oil companies are able to grow to today's size for a reason.

[ItsAValueTrap]

So when you say independent oil and gas companies, do you mean the junior ones

Yeah I mean the junior ones.

[JSArbitrage]

 

One rule of thumb to keep in mind is that any acquiror that buys reserves and books goodwill as a result are massively overpaying.  Most major accounting firms have the idea that there is almost never goodwill in an E&P acquisition.  They will pull every lever they can possibly pull (within the bounds of reason) to eliminate goodwill.  So you know if an E&P company is repeatedly doing deals with goodwill, they are paying huge premiums and will probably have a write-down sooner or later.

 

Your rule of thumb is not true.  If a company can buy another that has reserves worth $1 billion but only paid $500 million to develop those reserves will be worth more than the value on the books, period.  The problem is rarely does many oil and gas firms earn high returns on capital to generate goodwill.

 

I don't think you quite understand purchase accounting. If Company X buys Company Y for $1B in total consideration, the only way goodwill exists is if there is not enough identifiable assets (tang/intang) to allocate to the purchase price.  In oil and gas, almost all the major accounting firms hold the opinion that goodwill almost never exists in an E&P acquisition.  Therefore, the value of the oil and gas properties becomes the plug value.  They literally back into the value of the O&G properties.  They use DCF and market approach and pulls the levers as needed to ensure that goodwill no longer exists in the allocation.

 

The only way accounting goodwill exists in an E&P transaction is that the price paid was so high that levers can't be pulled any more.  So accounting firms will start pushing the discount rate down.  10% discount rate results in goodwill? Try 9%? Still goodwill? Try 8%.  Still goodwill? Start moving reserve adjustment factors. Put 100 percent good for all proved.  Still goodwill? Start increasing percent good on the probables.  Etc. etc. 

 

Historical development costs are basically irrelevant to purchase accounting because reserves are adjusted to fair value at the closing date.  If it costs $100M to drill and you have $1B worth of reserves, it's booked at $1B.  No goodwill.

 

So that's why I say be careful if E&P companies have a history of booking goodwill on acquisitions.  It usually means that every rosy possibility was considered in valuing the reserves and goodwill somehow still existed (which it shouldn't.)

[kevin4u2]

 

One rule of thumb to keep in mind is that any acquiror that buys reserves and books goodwill as a result are massively overpaying.  Most major accounting firms have the idea that there is almost never goodwill in an E&P acquisition.  They will pull every lever they can possibly pull (within the bounds of reason) to eliminate goodwill.  So you know if an E&P company is repeatedly doing deals with goodwill, they are paying huge premiums and will probably have a write-down sooner or later.

 

Your rule of thumb is not true.  If a company can buy another that has reserves worth $1 billion but only paid $500 million to develop those reserves will be worth more than the value on the books, period.  The problem is rarely does many oil and gas firms earn high returns on capital to generate goodwill.

 

I don't think you quite understand purchase accounting. If Company X buys Company Y for $1B in total consideration, the only way goodwill exists is if there is not enough identifiable assets (tang/intang) to allocate to the purchase price.  In oil and gas, almost all the major accounting firms hold the opinion that goodwill almost never exists in an E&P acquisition.  Therefore, the value of the oil and gas properties becomes the plug value.  They literally back into the value of the O&G properties.  They use DCF and market approach and pulls the levers as needed to ensure that goodwill no longer exists in the allocation.

 

The only way accounting goodwill exists in an E&P transaction is that the price paid was so high that levers can't be pulled any more.  So accounting firms will start pushing the discount rate down.  10% discount rate results in goodwill? Try 9%? Still goodwill? Try 8%.  Still goodwill? Start moving reserve adjustment factors. Put 100 percent good for all proved.  Still goodwill? Start increasing percent good on the probables.  Etc. etc. 

 

Historical development costs are basically irrelevant to purchase accounting because reserves are adjusted to fair value at the closing date.  If it costs $100M to drill and you have $1B worth of reserves, it's booked at $1B.  No goodwill.

 

So that's why I say be careful if E&P companies have a history of booking goodwill on acquisitions.  It usually means that every rosy possibility was considered in valuing the reserves and goodwill somehow still existed (which it shouldn't.)

 

Gotcha, I stand corrected.