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.

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A Crash Course in Refining Fundamentals


  • 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.

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UPDATE: US Employment

Greetings, all.

My father just responded to my June 13, 2013 post, “US Employment: What’s Wrong With This Picture?“, with the following WSJ article: “The Hidden Jobless Disaster”.

Especially salient to my analysis on incentives is the following passage:

…research by the University of Chicago’s Casey Mulligan has suggested that because government benefits are lost when income rises, some people forgo poor jobs in lieu of government benefits—unemployment insurance, food stamps and disability benefits among the most obvious. The disability rolls have grown by 13% and the number receiving food stamps by 39% since 2009.

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S&P 500 Historical Valuation

Dr. Robert Shiller is a leading authority on behavioral finance, a field that attempts to get at the heart of market economics. What’s at this heart? People, naturally. What’s the point? I argue that it behooves traders and investors alike to retain some degree of insulation from the general population’s view on value, and instead rely on a more rational definition of value. Schiller’s cyclically-adjusted Price-to-Earnings (CAPE) and Price-to-Earning-to-Growth (CAPEG) ratios are indeed very simple, rational, and hold a great degree of predictive power.

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The Labor Force: Who’s Leaving It?

In my last post, “US Employment: What’s Wrong With This Picture?“, I showed the workers of leaving the US Labor Force at an unprecedented rate. But who is leaving and why?

Obviously, workplace dynamics have changed dramatically (e.g., workers are retiring later in life and women have increasingly become a workforce with which to be reckoned). But how and by how much?

Specifically, what remained unclear was why the labor force, defined as the sum of employed and unemployed working age (25 – 54 y/o) adults, had undergone a secular increase from the 1940’s into the 2000’s and is now apparently reversing course. Is this due to a great dislocation of our perceptions and expectations? Perhaps there are other factors at play?

I can speculate all I want, but ultimately I need data to back my assertions. Fortunately, Quandl is making my data-life easier.

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US Employment: What’s Wrong With This Picture?

I would like to thank Quandl for providing me with this idea in their recent “Dataset of the Day“.

Often I have heard the Bureau of Labor Statistics’ (BLS) and the Federal Reserve’s (Fed) numbers on unemployment are misleading. Even though they show that unemployment is down, it now is obvious that employment is not necessarily up. A shrinking labor force may be a disruptive trend, and is surely worth watching.

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