Seeking Alpha: Imperial Oil — Levered Exposure To Oil Prices At A Fair Price

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.

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Seeking Alpha: Cenovus’ Consolidation Offers Counter-Cyclical Upside

Source: CVE Corporation Presentation. Cenovus announces acquisition of Western Canadian assets. Pg 4. 29 Mar 2017. available: http://www.cenovus.com/invest/docs/2017/acquisition-western-canadian-assets-presentation.pdf

  • 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.

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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 UntSource: Greg Evans. Sunburst – Pumping Unit. Art Gallery of Greg Evans

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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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Drilling for Value, Pt. 4: The Economics of Petroleum Exploration and Production

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. 

Summary

  • 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.

Figure 1: Pecos, Texas Oilfield
February-22-Hogue-1937-Pecos-AOGHS
Source: Alexander Hogue. Pecos, Texas Oilfield. 1937

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.

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Drilling for Value, Pt 3: The Fundamentals of Upstream Investing

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.

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Footnotes   [ + ]

1. Roberta Olmstead. Competitive advantage in petroleum exploration. Oil and Gas Journal. 23 April 2001

Drilling for Value, Pt 2: Fundamentals of Petroleum Resource Management

Author’s note: this article has been heavily redacted since its original publish date. Content on the upstream business was redacted and re-posted elsewhere in order to expand more on the business fundamentals there and the resource fundamentals here.

Summary

  • The previous installment established that cost-of-supply is the overwhelming driver of petroleum exploration and production value.
  • The geological processes which resulted in the accumulation of hydrocarbons and resulted in the formation of petroleum reservoirs strongly influence the quantities of recoverable resources and their production characteristics.
  • Additionally, geology is a key determinant of cost, and therefore also a key driver of upstream value.
  • A grasp of geological concepts facilitates the interpretation of language within company disclosures — ultimately helping investors identify instances where value and price diverge.

Figure 1: A Different Kind of LeaseA Different Kind of Lease
Source: Art and Framing Plus

Overview
Part 1 of this series broadly addressed the fundamentals of the broader petroleum value chain, especially from an investor’s perspective. This installment deep dives on the fundamentals of economic geology (i.e., petroleum resource management) in order to impart a holistic view of geological and technical factors governing petroleum recovery. Since cost-of-supply is the overwhelming driver of value in the upstream oil and gas business, and geology is often the overwhelming factor underlying cost, a basic understanding of petroleum geology is necessary to fully grasp the economic drivers. Topics include petroleum geology, petroleum geography, resource classification, petroleum recovery, and the fundamentals of resource quantity and production estimation. Following installments will leverage this knowledge to address the business fundamental of exploration and production, and subsequently the economics of the upstream business. At a later point, these foundations in petroleum geology, business fundamentals, and economics will help us maximize the utility of financial reports and unravel accounting minutiae.

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False Profits: A Prodigal Value Investor Returns from the Oil Patch

Summary

  • There are two ways to create value in the upstream business: find and produce extremely low cost-of-supply resources; and, integrate along a value chain in order to sell at relatively higher prices.
  • Of these two options, rational integration is far more scalable and repeatable.
  • Data of historical free cash flows overwhelmingly supports the notion that integration is the strategy most conducive to value creation.
  • However, omens of an oil and gas upstream and midstream investment bubble have not been conducive to identifying investment opportunities.

I watched There Will Be Blood a few years back, right after oil prices tanked in late 2014. A scene stood out in my brain, though I never really figured out why until now.

2007_there_will_be_blood_001Source: Critical Analysis: There Will be Blood (Paul Thomas Anderson, 2007). The Film Emporium Blog. 9 October 2010

It goes like this:

Our protagonist, Daniel Plainview is “hunting quail” — a cover for prospecting for oil — on private property with his adopted son HW. HW runs off to retrieve a downed quail and returns to his father with a tarry black substance covering the bottom of his shoes. They soon realize that they have found their “pay sand”.

Then, as they both gaze over the horizon, we learn about Daniel’s vision; one which foresaw the crux of petroleum economics through the century and beyond.

so-so. if there’s anything here…we take it to the sea — we can go into town and see a map – but what we do — we take a pipeline from here to Port Hueneme or Santa Paula and we make a deal with Union Oil — this is what we do and we don’t need the railroads and the shipping costs anymore, you see? …and then we’re making money. we make the real money that we should be making and we’re not throwing it away — otherwise it’s just mud.

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

Summary:

  • 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
mead-schaeffer-drilling-for-oil-november-9-1946_a-g-8290694-8880742
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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Looking for Value in the Oil Patch? Try the Value Chain.

Summary

  • It is difficult to locate value within the conventional notion of the petroleum industry, especially in the upstream.
  • A holistic approach to the much broader petrochemical and petroproduct value chains suggests that most of the economic value in the petrochemical industry is created and realized downstream.
  • Vertically integrated value chain players are able to source cheap inputs and produce value-added products with intangible values.
  • A simple case study of 10 publicly traded companies which occupy the “sweet spot” of the petroleum value chain corroborates the intuition regarding economic value realization.
  • The value chain analysis framework can be applied to any situation in which raw materials are liberated from commodity market forces.

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