“[Certainty can] seem like a good idea, but actually lead us into trouble… The story here revolved primarily around the stochastic nature of product development… Succeeding in product development requires the discovery and exploitation of options where there is an asymmetry to the payoff function.” […]
Image source: Imperial Oil Corp. Corporate Overview – Winter-Spring 2017. pg. 5
- Imperial Oil Corp is a rationally integrated enterprise — assessing any given business segment in isolation ignores synergies which are especially important during the lower half of the commodities cycle.
- The upstream business segment, by far the largest in terms of capital investment, is heavily exposed to Canadian oil sands projects which are marginal in the current commodity prices environment.
- Yet, records profits from the downstream and chemical business segments demonstrate how they have benefited from cost advantaged feeds.
- In the current commodity price environment, IMO’s common shares are likely fairly valued $22 to $32 per share; there is significant uncertainty in that estimate.
- Given non-compelling valuation and risks, I do not hold the equity outright. However, I believe that call options may provide favorable risk-reward characteristics given their leverage to crude oil prices.
- Cenovus’ expanded asset base, following the $C17.7 Bn acquisition from ConocoPhillips, will be largely of high quality and is expected to more than double 2017 production.
- Its oil sands position is not terribly exciting in terms of growth, but it does promise commodity-price resilient cash flows which can be used to fund future growth.
- The companies largely expanded position in the Canadian Deep Basin may be largely under-recognized as a leading foothold in what my be aptly called “The Permian in the North”.
- Pre-acquisition, I posit that the current stock price of around $10 moderately undervalues the company and largely discounts potential commodity price driven and/or geological upside.
- Given the dearth of apparent opportunity in the upstream oil and gas space, CVE is favorite yet long idea of 2017.
Date of Source: 2016
Commodities trading – supply of the basic staples that are converted into the food we eat, the industrial goods we use, and the energy that fuels our transport and heats and lights our lives – is one of the oldest forms of economic activity, yet it is also one of the most widely misunderstood. At no time has this been truer than in the last 20 years, with the emergence of a group of specialist commodities trading and logistics firms operating in a wide range of complex markets […]
- 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).
- 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
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.
Date of Source: 12 Apr 2016
As quants, we’re all aware that every model has a shelf-life… a similar pattern applies to the world of data. Rare, unique and proprietary data eventually diffuses and becomes commonplace, easily available, edgeless data. The best analysts constantly reinvent their models, to avoid their inevitable obsolescence. Today, they’re venturing into the world of alternative data as a new source of alpha. […]
Note: this post has been heavily redacted since its original data of publication in order to expand on the fundamentals of petroleum geology and the upstream business elsewhere.
- Economic models use assumptions which simplify the effects of accounting, taxes, regulations, and other minutiae in order to glean insights into the drivers of market behavior and value.
- The effects depletion and commoditization, relatively low cash costs, and often prohibitive resource replacement costs drive the endemically cyclical petroleum investment cycle
- Petroleum economics are strongly levered to petroleum prices and other extrinsic factors.
- Maintaining a sufficiently low cost of supply is the primary operational lever capable of creating long-term investment value in the upstream business.
- Timings of costs are a key consideration for evaluating investment decisions — known discount rates simplify decisions regarding timing preferences.
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: Content on the geological considerations of petroleum resource management was redacted and re-posted elsewhere in order to expand more on the resource fundamentals there and the business fundamentals here.
- The upstream business cycle can be sub-divided into five functional areas: Exploration and Evaluation, Development, Production, Marketing, and Retirement.
- The exploration and evaluation functional area creates potential value by discovering quantities of petroleum and reducing geological uncertainty.
- The remaining business functional areas realize geological value potential by adhering to more closely to the cost-centric logic of conventional value chain analysis.
- Integration between business units maximizes the value potential of an exploration and production concern.
- Markets for upstream assets are minimally inefficient; retail investors must think outside the box if they hope to compete with sophisticated and well-capitalized institutions.
Figure 1: Coyote Hills, California
Source: Coyote Hills, California. Lee Alban Fine Art.
Different petroleum exploration and production (E&P) businesses operate differently depending on their focuses and asset bases. Major differences can also be observed between various operators within a single basin. However, their business models are all strikingly similar: get oil and gas out the ground and sell it to the highest bidder. A generalized upstream business model has five functional activities: exploration and evaluation (E&E); development; production; marketing; and retirement. The E&E function essentially drives the process of identifying opportunities for potential value creation — it also broadly includes the evaluation of assets for acquisitions and divestitures (A&D). The remainder of the business functional areas support the exploitation of this value potential. In this way, the exploration functions abide by the principles value configuration theory 1, whereas the production abides by conventional industrial logic according to Michael Porter’s value chain framework.
It is notable that an upstream operating concern which is rationally integrated into a larger petroleum value chain does not need to be particularly good at either activity in order to create value.
Footnotes [ + ]
|1.||↑||Roberta Olmstead. Competitive advantage in petroleum exploration. Oil and Gas Journal. 23 April 2001|