The Economics of the Upstream Petroleum Industry
The economics of the petroleum extraction is overwhelmingly colored by the economic factors of depletion and commoditization. Due to the fact that production depletes limited natural resources, the upstream industry must constantly explore for and develop additional resources. Given that the capital investments required to replace depleted resources are usually quite significant in relation to operating costs, resource replacement is a primary driver of costs. Commoditization describes the lack of differentiation in upstream business models and their end products. As a direct result of commoditization, the value propositions of upstream businesses are strongly levered to external market conditions (i.e., namely prices). Taken together, high replacement costs and supplier susceptibility to external market conditions have resulted in endemically cyclical petroleum supplies and prices.
Author’s note: this article has been heavily redacted since its original publish date. Content on the upstream business was redacted and re-posted elsewhere in order to expand more on the business fundamentals there and the resource fundamentals here.
The previous installment established that cost-of-supply is the overwhelming driver of petroleum exploration and production value.
The geological processes which resulted in the accumulation of hydrocarbons and resulted in the formation of petroleum reservoirs strongly influence the quantities of recoverable resources and their production characteristics.
Additionally, geology is a key determinant of cost, and therefore also a key driver of upstream value.
A grasp of geological concepts facilitates the interpretation of language within company disclosures — ultimately helping investors identify instances where value and price diverge.
Overview Part 1 of this series broadly addressed the fundamentals of the broader petroleum value chain, especially from an investor’s perspective. This installment deep dives on the fundamentals of economic geology (i.e., petroleum resource management) in order to impart a holistic view of geological and technical factors governing petroleum recovery. Since cost-of-supply is the overwhelming driver of value in the upstream oil and gas business, and geology is often the overwhelming factor underlying cost, a basic understanding of petroleum geology is necessary to fully grasp the economic drivers. Topics include petroleum geology, petroleum geography, resource classification, petroleum recovery, and the fundamentals of resource quantity and production estimation. Following installments will leverage this knowledge to address the business fundamental of exploration and production, and subsequently the economics of the upstream business. At a later point, these foundations in petroleum geology, business fundamentals, and economics will help us maximize the utility of financial reports and unravel accounting minutiae.
Our protagonist, Daniel Plainview is “hunting quail” — a cover for prospecting for oil — on private property with his adopted son HW. HW runs off to retrieve a downed quail and returns to his father with a tarry black substance covering the bottom of his shoes. They soon realize that they have found their “pay sand”.
Then, as they both gaze over the horizon, we learn about Daniel’s vision; one which foresaw the crux of petroleum economics through the century and beyond.
so-so. if there’s anything here…we take it to the sea — we can go into town and see a map – but what we do — we take a pipeline from here to Port Hueneme or Santa Paula and we make a deal with Union Oil — this is what we do and we don’t need the railroads and the shipping costs anymore, you see? …and then we’re making money. we make the real money that we should be making and we’re not throwing it away — otherwise it’s just mud.
This series is geared toward value-oriented investors who have an interest in valuing upstream oil and gas assets.
This article touches on the economic fundamentals and valuation concepts for nearly every other line of business within the oil and gas value stream.
The economics of different types of oil and gas assets vary significantly: businesses which are more involved with the extraction of oil and gas from reservoirs tend to be more vulnerable to external market forces.
Valuation of upstream assets and companies can be very difficult to learn but also very repeatable once the initial learning curve has been overcome.
Figure 1: Drilling For Oil by Mead Schaffer as Appeared on The Saturday Evening Post, 9 November 1946
Large, integrated oil and gas companies have become a cornerstone for investors seeking stable and growing dividends. Supermajors Exxon Mobil (XOM) and Chevron (CVX) are included in S&P’s Dividend Aristocrats, an index comprised of stocks from the S&P 500 which have been increasing dividends for the last 25 years or more. Yield-oriented investors typically value companies according to their dividends — their yields, abilities to grow, and resiliencies to adverse market conditions. This series of articles is not geared to these people.
Nor is this series intended to appeal to appeal to macro investors. Forecasting macroeconomic conditions is an arcane art of which I am not adept. While it is important to understand the fundamental forces at play which can make or break a business endeavor, I will spend minimal effort discussing petro-politics, the petro-dollar, or forecasting supply and demand. Sorry, OPEC.
This series of articles is meant to appeal to value-oriented investors – those who desire to invest according to perceived discrepancies between value and price and those who desire to locate consistent value creators and/or destroyers within an industry. Valuation of upstream oil and gas exploration and production (E&P) assets will be the primary focus, but I will also cover midstream and downstream assets. Discussions regarding the valuation of other corporate and financial assets and liabilities will chiefly examine decisions regarding how they articulate within the valuation of entire companies.
PBF Energy (PBF) is a bargain at current market prices. PBF’s adept management team, in conjunction with private equity partners, acquired its core refining assets at fire sale prices in 2010 and 2011. Among these assets are the Paulsboro and Delaware City refineries which, following initial turnarounds, are now the crown-jewels of the East Coast (PADD 1) refining system. East Coast refineries have historically lacked the structural advantages of their Mid-Continent and Gulf-Coast counterparts. However, management’s aggressive investment program in a “crude-by-rail” logistical infrastructure promises to close the gap by adding much lacking optionality through access to cost advantaged crudes. Although the ownership structure has legacy problems and the company will undoubtedly continue to face cyclical margin and secular regulatory issues, the stock is much too cheap. A discounted cash flow analysis and an economic book value analysis convergingly indicate that the stock is fairly valued at around $50 per share (about 60% higher than current prices of about $31/share). Continue reading →
Valero Energy Corporation’s (VLO) conservative valuation reflects a history of and expectations for cyclical margin pressures, secular regulatory pressures, and a management regime which does not create excess long-term shareholder value.
Management has singled out asset drop-downs to company sponsored MLP, Valero Energy Partners (VLP), as the most promising avenue for unlocking shareholder value.
Although the value gap between VLO and VLP is real, unless management radically accelerates VLP’s financing trajectory, the drop-down strategy will not significantly drive excess returns for VLO shareholders.
Disproportionate focus on arbitraging market value dislocations could detract from more enduring drivers of long-term value such as distressed asset acquisitions and continuous rationalization of core refining and logistics assets.
VLO’s core refining assets are among the best positioned and most complex in the world. If competently utilized, these assets are worth significantly more than the company’s market capitalization.
Refiners make money by cracking crude oil throughputs into valued-added products (i.e., yields). Crack spreads are cyclical and volatile.
Refiners have adapted to margin volatility by engaging in derivatives contracts which off-set short and medium commodity price risks and by investing in assets which are able to process cost-advantaged crudes and optimize yields of higher value products.
Vertically integrated refiners are further able insulate themselves from commodity risks and exert more pricing power.
Ceteris parabus, long-term crack spreads will be upheld simply due to the fact that markets tend to value refining assets at or below their replacement costs (RCN).
Compliance and regulatory measures are a more serious threat to the long-term viability of domestic refiners since they often elicit unintended economic consequences.