Drilling for Value, Pt. 1: The Fundamentals of the Petroleum Industry


  • 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
Source: Art.com

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.

Principles of Valuation
Asset valuation is based on the time value of money principle (i.e, a dollar today is worth more than a dollar tomorrow). The most discrete way to incorporate that central premise into a financial model is through discounted cash flow analyses (i.e., the present value of any asset is equal to the sum of its discounted cash flows), whether these cash flows are due to internally generated funds and/or asset sales. When valuing complex business entities which engage in multiple lines of business, a sum of the parts approach is an acceptable practice.

The approaches presented herein are intended to model future market behavior under the assumption that security prices “want to find” their intrinsic values. However, intrinsic value other than market price is subjective. Despite our best efforts, markets are the products of human behavior and therefore do not behave according to models. Skill, luck, discipline, and a healthy appreciation of the limitations of any and all approaches to asset valuation are the essential traits of successful and emotionally stable investors. This series of articles will attempt to impart the skills required of a disciplined approach to investing in order to profit from any luck and graciously deal with adversity.

The Economics of Oil and Gas.
Different types of businesses in the oil and gas industry which own and/or operate significant core oil and gas assets have been likened to a stream – the farther upstream they are, the closer they are to source of raw goods – the father downstream they are, the closer they are to finished goods and the consumer.

Upstream businesses primarily focus on oil and gas exploration and production (E&P). Downstream businesses focus on refining and processing petroleum for its end uses as fuel and various petroleum derivatives. At the far end of the downstream subindustry are businesses that specialize in processing intermediate petrochemicals into high value products. Midstream businesses connect all the components of all the value stream. Power generating and gas transporting utility companies operate similar assets similarly to other midstream and downstream businesses, but are not typically considered to be a part of the overall oil and gas value stream due to significant differences in regulations which fundamentally change the underlying economics. At the periphery of the value stream are hosts of business which service the oil and gas industry, but are not considered to be to direct participants in the value stream.

Figure 2: The Petroleum Value Stream
Petroleum Value Stream
Source: Author

The closer the business is the extraction of raw commodities, the more vulnerable it is to external market forces. As the saying goes in this industry, “the further away you are from the oil fields, the safer your job is.” Expanding on the notion, the closer a business is to commodity production, the more reliant it is on market conditions. While upstream companies exert some control over costs, they have very limited control over prices of goods sold. Vice, the farther one is from extracting the raw commodity, the more operating levers at its disposal (e.g., to exert control over prices through product differentiation) and therefore the more control it has of its own destiny.

Although the basic tenets of asset valuation are consistent across all asset classes, different categories of assets in the oil and gas industry respond to different economic conditions differently. Likewise, different valuation approaches are used to account for the fact that different types of business are calibrated to different economics drivers. Just as further downstream business are more differentiated in their approaches to turning profits, the valuation approaches used become increasingly nuanced, but not necessarily more complicated.

Upstream Fundamentals
Profits of an “upstream” oil and gas E&P business which primarily finds and produces oil from underground reservoirs are strongly levered to the absolute sales price of crude oil. While upstream operations are differentiated according to the types of reservoirs from which they produce, all do basically the same thing: get oil and natural gas out of the ground.

Figure 3: Categories of oil and natural gas occurrence as used in the National Assessment of Oil and Gas Projects
Categories of oil and natural gas occurrence as used in the National Assessment of Oil and Gas Project
Source: Troy Cook. U.S. Geological Survey Digital Data Series DDS–69–D. Chapter 23 of Petroleum Systems and Geologic Assessment of Oil and Gas in the Southwestern Wyoming Province, Wyoming, Colorado, and Utah. 2005 (as from Schenk and Pollastro, 2002).

The value of upstream assets is based on estimates of the quantities and economics of petroleum which will ultimately be recovered from reservoirs deep underground. The recoverable quantities are a primarily a function of applied technology. Improving technology allows more of the resource to be covered more economically. However, resource depletion makes it increasingly difficult and costly to extract. The economics of recoverable petroleum resources are a function of internal factors and external forces. Reserves are quantities of petroleum which geologist estimate will be recovered going forward — to qualify, a reserve must be technically and economically recoverable. Due to the technical constraints of assessing petroleum geology and difficulty in predicting future economic conditions, assessing quantities of ultimately recoverable petroleum resources is inherently estimative.

Valuing upstream assets and companies requires specialized knowledge of industry-specific vernacular, generally accepted accounting practices (GAAP), and the skills to properly interpret commonly used financial and performance metrics. Once an investor learns the requisite skills and become familiar with the abundance of analytical tools and datasets available, the process of valuation becomes much more straightforward. The abundance of tools and data, related perhaps to the lack of differentiation within the industry, vary greatly with regard to breadth, depth, quality, and price.

Midstream Fundamentals
Profits of a “midstream” oil and gas company, which transports and distributes unrefined and refined products, are tied to the company’s ability to exploit regional pricing differentials and/or market this capability through structured throughput and takeaway commitments. Midstream companies which derive revenues from long-term contracts will be relatively more insulated from short-term commodity price shocks, but the profitability of nearly all players within the midstream segment are levered to commodities over the long-run.

It is relatively easier to value midstream asset since they are located above ground (i.e., known versus estimated) and do not deplete like a natural resource. However, the approach by which midstream assets should be valued is more nuanced depending on the types of assets and where within the stream the underlying assets reside. Although the name would suggest that midstream assets lie between the upstream and downstream, this is not always the case. In practice, midstream assets are the glue of the oil and gas value: tying oil and gas producers with refiners; refiners with distribution and retail hubs; storage hubs with export hubs; and so on. The locations of these midstream assets within the greater value stream greatly influence their revenue models and useful lives (and thereby economic value propositions). For example, central products pipelines typically incur steady revenue streams and are very long lived; the economics of crude oil and natural gas gathering facilities and pipelines depend strongly on localized oil field activity and are therefore typically much riskier.

Downstream Fundamentals
Profits of a “downstream” oil and gas company which refines raw inputs (i.e., feedstocks) into finished products (i.e., “throughputs”) depend mostly on the company’s ability to exploit pricing differentials which exist between products as well as regional pricing differentials. Over the long term, the most economical refiners are those with the most complex assets and flexibility to quickly optimize their products slates to take advantage of pricing differentials as they arise.

If only core refining assets are considered (i.e., specialized petrochemical processing units and facilities are not considered), valuing downstream assets is relatively simple and repeatable. Values of refining equipment can be easily standardized with regard to throughput and takeaway capacities, asset complexity, asset replacement costs, maintenance capital costs, and normalized margins. Also, the data for doing such is fairly readily available.

Please see a previous post, A Crash Course in Refining Fundamentals, for a much more thorough discussion on downstream economics and valuation.

Value Stream Fundamentals: Petrochemicals and Retail
At the furthest end of the downstream petrochemical value stream are specialty petrochemical and petroleum retail companies. These segments comprise the most expansive arm of the petroleum value stream and are the most insulated from company price shocks and other external market conditions.

Specialty petrochemical business operate much like refineries except that they produce more valuable intermediate-products like olefins and/or end-products like plastics, waxes, paints, synthetic fibers, cosmetics, food additives, and chemical reagents.
Retail petroleum businesses, such as gas stations, also operate like refiners in that the profitability of petroleum sales are levered to regional pricing differentials. However, they are able to insulate themselves from commodity price conditions by diversifying into non-petroleum retail products and services, which often command much higher margins.

Valuing both specialty petrochemical operations and petroleum retailer is more nuanced, but not necessarily more complicated. Due to greater degrees of differentiation between these operations, more consideration should be given to the degree of which the business is commodity versus retail-driven. In many ways, valuing them is relatively simple because their assets do not deplete and their profit margins tend to be more insulated than companies further upstream. However, acquiring sizable data sets and deriving standardized metrics for doing so is more difficult. In general, the closer the business is to retail consumers, the more nuanced, but not necessarily difficult, the approach to valuation should be.

A more thorough discussion regarding the petrochemical value chain can be found within a previous post.

Oil and Gas Services Fundamentals
Although not considered to fall within the core oil and gas value stream, profits of oil and gas service operations tend to be strongly correlated to their customers’ margins. Oil and gas services firms include contract drillers, parts and equipment suppliers, and environmental and geophysical services. Often, service-based business segments are integrated into larger E&P firms.

Similar to petrochemical and retail businesses, valuation approaches need to take into consideration the economics of these businesses. Non-cyclical and well-entrenched businesses will be able to withstand long industry downturns. On the other hand, profits of cyclical businesses will be extremely levered to the discretionary spending habits of their customers.

A far more detailed primer on the oil and gas services industry can be found on Investopedia.

Considerations for Vertically Integrated Oil and Gas Companies
“Vertically integrated” oil and gas companies own and operate significant quantities of assets across the petroleum value stream, including business units which service the core assets. Integration can balance out a company’s sensitivities to varying economic conditions and the increased scale can result in less dependence on external service firms and therefore greater retained earnings. Although scale, diversification, and technological leadership have helped major integrated oil and gas companies withstand market cycles, size comes at the cost of specialization, agility, and sometimes innovativeness. The downsides of size have been evident as several supermajors have floundered in recent attempts to gain competitive footholds in unconventional resource categories (e.g., tight oil and gas, bitumen, LNG, etcetera).

Figure 4: Components of a Vertically Integrated Petroleum CompanyVisio-Oil-Gas-Value-Chain-Diagram-140303b-dj-updated2Source: BSI. Scope of BSI’s Oil and Gas Supply Chain Consulting Services

If one has the tools and expertise to value their constituent assets and business units, a sum of the parts approach is the simplest method to value complex businesses, such as integrated oil and gas. A sum of the parts approach values distinct business units within the larger enterprise separately; the sum values of these values equals the value of the whole. While the premise is intuitive, empirical evidence indicates that other market forces are at work. A wave of consolidation in 1960s and 1970s was spurred by the fact that conglomerates commanded higher valuations than the sum of their constituent companies’ values, supposedly due to the positive effects of waste elimination and “synergy”. Since the late 1980s, the opposite has occurred, supposedly due to the loss of agility, innovativeness, and upside potential that large companies often suffer. Adjustments can be made to compensate for shortcomings of this approach, but it’s far more important to recognize that all models will ultimately breakdown in their attempts predict human behavior.

Why Focus on the Upstream?
The enormity of the petroleum value stream touches nearly every aspect of modern life – it’s literally everywhere. So I find it interesting that I’ve personally gravitated almost exclusively toward the upstream, having devoted considerable time and energy to unlocking its secrets.

It is definitely not due to sound economics or attractive asset valuation, for starts. In previous writings, I have consistently lamented at the poor economics of oil and gas upstream companies, even when oil was at $60/Bbl. The capital intensive nature of the business and accounting distortions enable these companies to declare profits while consistently burning through cash. Also, in past articles, I have noted that most equity valuations of upstream companies discount a return to much higher commodity prices, often above $100/Bbl WTI, underscoring the commoditization of the business model which is dependent on and susceptible to external market conditions. In most cases, investing in upstream oil and gas companies is ceteris paribus a bullish commodity bet.

It is also definitely not due to the ease of assessing economic value. There is a great deal of uncertainty involved in estimating the quantities and economics of what the eye cannot see (i.e., underground petroleum resources). Furthermore, upstream companies are subject to a number of industry-specific accounting conventions which can cause financial reporting to understate historical cost bases and overstate returns on capital. Cutting through the accounting and regulatory noise by valuing the underlying assets requires a thorough grasp of specialized approaches, tools, and data sources.

And finally, it is not want of alternatives. The economics (as well as asset valuations) of the downstream, including the specialty petrochemical, sector are superior in nearly all ways. Also, valuing midstream and upstream assets tends to involve less uncertainty and to be simpler.

Over time, I’ve come to understand that my fixation is actually rooted in the lack of differentiation – i.e., the process of valuing upstream assets and companies promises to become very repeatable once the initial learning curve has been overcome. Despite the fact that different E&Ps often specialize in different recovery techniques and focus on different regions with unique geologies, they all do pretty much the same things – i.e., explore for and produce oil and natural gas. A lack of differentiation means that most of the skills, tools, and industry-specific knowledge used in valuing one E&P can be used in valuing another. This, and the industry’s immensity has resulted in an abundance of analyst coverage and data offerings which further facilitate the valuation process. Increasing familiarity with the valuation process (and access to professional resources and contacts) counterbalances the original drawbacks to investing in upstream oil and gas assets and companies.

Although this article will probably be the least technical in this series, it very well could be the most difficult to write and (for the reader to) read. Having come into this business last year with almost no specific background in oil and gas, I mistakenly lumped the entire industry together. However, different segments within the oil and gas value stream exhibit very disparate economic characteristics and respond very differently to a variety of market conditions. Trying to mentally house this entire industry under a unified analytical framework took significant time and effort. Furthermore, even though the upstream is the least differentiated segment of the broader value stream, it is probably the most difficult to assess due to its fundamentally uncertain and estimative nature. The next article in this series will address these difficulties.

In the next installment, I will dive deeper into the fundamentals of the upstream oil and gas industry. The article will focus on imparting a holistic understanding of petroleum resources, including debunking the industry-standard and most frequently reported metric for assessing economic value: reserves. The following article will also begin to disentangle industry accounting standards and financial reporting conventions in order to facilitate an understanding of the real economic costs associated with the upstream business. I will also touch on several interdisciplinary topics which further facilitate economic modelling. The goal is to impart the knowledge needed to estimate future production and the costs associated with the future production of developed and undeveloped resources in order to ultimately determine the economics thereof under various market conditions.