Drilling For Value, Appendix B: Commodity Price Forecasts (or, why commodity price forecasts are mostly worthless)

Summary

  • Equity investments into upstream oil and gas companies are largely levered commodity price plays; long-term total returns barely offset the carry costs of taking a long position in oil futures.
  • There are multitudes of ways by which experts seek to forecast future commodities prices; most don’t work.
  • The failure of forecasting should not be surprising if the Efficient Market Hypothesis is even partly correct.
  • Even barring market efficiency, behavioral models provide ample reason for the widespread inaccuracy of forecasts.
  • The idea that commodities prices — including oil — follow a random walk is both overwhelmingly supported by evidence and practical.

Figure 1: Black Gold

Source: Andy Thomas. Black Gold

Evidence overwhelmingly supports the notion that investments into upstream oil and gas producers are basically levered commodity price plays. This, and the fact that commodities producers are price-takers, indicates that petroleum economics are overly levered to commodities prices. It should follow, therefore, that an ability to accurately predict petroleum prices could result in advantageous market timing — i.e. investments in the right petroleum producing assets during the right times in the cycle. As a result of this ostensible potential for riches, prognosticators have devised multitudes of ways to forecast oil prices. Unfortunately, most of these efforts fall short of useful — no known forecasting approach, not even futures strip prices, significantly outperforms the assumption that price evolutions are random walks using out-of-sample data. This failure is not surprising, however, if we are to believe even a watered-down form of the Efficient Market Hypothesis (EMH).

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Drilling For Value, Appendix C: Discounting Theory and Practice

Summary

  • Discount rates are a cornerstone of modern valuation methods for discounting the value of expected future cash flows.
  • Upstream valuation professional systemically utilize elevated discount rates well in excess of rational expectations for long-run capital growth.
  • The use of elevated discount rates may have roots in Modern Portfolio Theory, heuristics regarding the aggregation of well-level economics, and as proxies for high expected rates of depletion.
  • Re-calibration of investors’ rational expectations indicates that lower discount rates may be more appropriate for evaluating long-run returns.
  • Discount rates are simply a means by which to equate dollars in different time-periods — any further deliberation is likely to suffer from diminishing returns.

Figure 1: Sunburst – Pumping UnitSource: Greg Evans. Sunburst – Pumping Unit. Art Gallery of Greg Evans

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Drilling For Value, Appendix A: Energetic Factors of Resource Economics

  • Energy Return on Energy Invested (EROEI) is a popular metric for resource quality which attempts to cut through economic distortions caused by taxes, subsidies, and current market conditions.
  • Energetic factors of resource intensity and efficiency also have practical applications for estimating long-term resource project economics.
  • Declining EROEIs, which have been hyper-politicized by peak oil enthusiasts, have been counteracted by gains in full-cycle energy efficiencies.
  • Though other energetic measures of return incorporate financial metrics, EROEI is still the purest key performance metric which exposes an energy resource’s underlying and long-term profit potential.


Source: Frank Reilly (Illustrator). Oilfield WorkerLiberty Magazine. 10 March 1945.

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Harvest Natural Resources: Classic “Cigar Butt” Stock Following Asset Sale

It used to be that making money in stocks was relatively easier. Father of value investing, Benjamin Graham, was known for his predilection of “cigar butt” stocks. That is, stocks which the market has thrown to the curb, forgotten, but which still might have at least “a few puffs” left in them. Harvest Natural Resources (NYSE: HNR), a small-cap oil and gas exploration and production (E&P) outfit focused on the development of known hydrocarbon deposits worldwide, may prove to be a classic example of such a stock.

With a market cap of $74.4 MM, and an indicated net current asset value (NCAV) very near that, Harvest Natural Resources, as a company, does not appear to be dead money. On the contrary, following an imminent sale of its Gabon asset for $32 MM, the company’s cash and receivable balance, less total liabilities, will exceed its market capitalization by $25 MM, implying that the market assigns a negative value to its expected future cash hoard. Worst case, investors could expect to get nearly all of their money back even after a 30% tax on a special dividend. However, if management can figure out a tax-advantaged means by which to utilize that sum, investors could benefit. A tax-free return of capital, which might be allowed under US tax law, implies a 33% short-term, low-risk return.

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