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.
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.
- 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 UntSource: Greg Evans. Sunburst – Pumping Unit. Art Gallery of Greg Evans
- 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 Worker. Liberty Magazine. 10 March 1945.
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 have little hope of competing toe-to-toe 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|
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.
Figure 1: A Different Kind of Lease
Source: Art and Framing Plus
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.
- 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
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.
- 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.