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.
An understanding of petroleum geology and petroleum resource management, including mechanisms of reservoir formation and accumulation, informs a holistic view of the upstream petroleum business.
The upstream business cycle can be sub-divided into five phases: Exploration and Evaluation, Development, Production, Marketing, and Retirement.
The upstream business is extremely commoditized and therefore its economics are extremely sensitive to external market forces.
Despite efforts to the contrary, the underlying driver of value creation within the business is maintaining a low cost of supply.
Enterprising investors might level the field with institutional investors by gaining a more holistic appreciation of the industry’s economic value proposition and the true value potential of its assets.
Part 1 of this series broadly addressed the fundamentals of the petroleum value stream. The rest of this series will dive deeper into the fundamentals of upstream business. The intent of this installment is to impart a holistic view of petroleum geology, petroleum resource management, and the fundamentals of a generalized upstream business model. The following installment will leverage this industry overview to address the economics of the upstream which, at a later point, will help us maximize the utility of financial reports and unravel accounting minutiae.
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.
In the world of investing and corporate finance, the Efficient Market Hypothesis (EMH) casts a long shadow. EMH states that a sufficiently liquid market reflects the “correct” price at all times. Since efficient markets factor in all known and relevant information at all times, it is therefore practically futile to attempt to predict the future direction of market prices. In other words, a blindfolded monkey throwing darts at the Wall Street Journal has about the same chance as beating the market averages as any professional investor. At one extreme, the founder of Vanguard Investments Jack Bogle revolutionized the mutual fund industry around cheap indexing, which he posited as the solution to efficient markets. At the other, Warren Buffet’s seminal essay, The Super-Investors of Graham and Doddes-ville, defends the notion that right-headed investors can carve out a significant edge 1. In the middle, you have the greater majority of investors who will likely cede that both extremes contain some amount of the truth. Even 2013 Nobel Laureate Eugene Fama, of the University of Chicago Booth School of Business, who is credited with developing EMH, has stated that “[asset prices] are typically right and wrong about half the time” 2. Being able to determine when they are right and when they are wrong is the holy grail to traders and investors alike. In order to investigate how correctly assets prices reflect all known information, we must develop an intuition and methodology for estimating the fair value of an asset. As we will discuss, just because a methodology is descriptive does not mean it is predictive (i.e., correlation does not imply causation). Continue reading →