Summary: Fifteen years ago it was common knowledge that oil and gas production in North America was in terminal decline. After decades of exploration, all of the profitable onshore oil and gas in Canada and the U.S. had already been discovered… While the attention of the majors was elsewhere, close to home something happened. Small companies run by entrepreneurial management teams cracked the code on vast amounts of oil and gas located here in North America. […]
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.
Summary: 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.[…]
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.