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.
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.
My intent is that this post become a living document which houses my own personal magnum opus on asset valuation. Herein and throughout I will posit certain axioms of asset valuation that I believe to be relevant for distinguishing between a thing’s market versus true value. Upon review, one might (correctly) deduce that none of these axioms are my original ideas. Continue reading →
Since late 2014, I’ve been trying to understand how to value upstream oil and gas companies in a way that anticipates future equity returns. Industry standard practices for financial modeling were illuminating, but they left me unconvinced that I could somehow out-compete smarter, more sophisticated, and better connected institutional investors at their own game. Moreover, nearly every time I tried to apply conventional (i.e., right-headed) valuation techniques to upstream companies, I came up with valuations that were either zero or far-below the current equity market capitalization. This suggested that some heavily discounted bonds would very likely repay par with interest. But seeing as I was full-time employed (and deployed) during those crazy times, I failed to act. Anyway, that boat has sailed…
Despite my lack of early success, I was driven on by a single premise: the lack of differentiation of upstream companies makes them incredibly easy to value once the initial learning curve has been surmounted.
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.
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 have little hope of competing toe-to-toe with sophisticated and well-capitalized institutions.
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 theory1, 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.
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.
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.
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.
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.