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. 


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


  • 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


  • 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
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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On Market Efficiency: Market Fair Value Estimates and the True Cost of Capital

In the world of investing and corporate finance, the Efficient Market Hypothesis (EMH) casts a long shadow. EMH states that a sufficiently liquid market reflects the “correct” price at all times. Since efficient markets factor in all known and relevant information at all times, it is therefore practically futile to attempt to predict the future direction of market prices. In other words, a blindfolded monkey throwing darts at the Wall Street Journal has about the same chance as beating the market averages as any professional investor. At one extreme, the founder of Vanguard Investments Jack Bogle revolutionized the mutual fund industry around cheap indexing, which he posited as the solution to efficient markets. At the other, Warren Buffet’s seminal essay, The Super-Investors of Graham and Doddes-ville, defends the notion that right-headed investors can carve out a significant edge [1. The Super-Investors of Graham and Doddes-ville]. In the middle, you have the greater majority of investors who will likely cede that both extremes contain some amount of the truth. Even 2013 Nobel Laureate Eugene Fama, of the University of Chicago Booth School of Business, who is credited with developing EMH, has stated that “[asset prices] are typically right and wrong about half the time” [2. The Super-Brainy Quote]. Being able to determine when they are right and when they are wrong is the holy grail to traders and investors alike. In order to investigate how correctly assets prices reflect all known information, we must develop an intuition and methodology for estimating the fair value of an asset. As we will discuss, just because a methodology is descriptive does not mean it is predictive (i.e., correlation does not imply causation).
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Protected: Shareholders Reject Yongye’s Buyout Offer: boon or boondoggle?

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The Ten Pillars of Quality Investing or: How I Learned to Stop Dumpster Diving for Undervalued Stocks

After recently having completed testing on a general method of discounted cash flow (DCF) analysis for estimating a broad basket of stocks’ intrinsic values, I became more concerned with “quality”. While DCFs remain the foundation of any sound business valuation, I discovered they are highly sensitive to the assumptions and data used. Slightly changing a minute detail can drastically influence the result causing an attractive investment to all of sudden seem not so attractive and vice versa. While relative valuation methods were a natural alternative (Wall Street’s preferred choice, in fact) to circumvent the sensitivity issues, I was inclined to believe that an ability to define robust ‘quality factors’ would complement the ideological purity of the discounted cash flow approach much better. The purpose of this discussion is to demonstrate that a good company can indeed also be a good investment.
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Bloomberg Businessweek Makes Cash Flow Analysis Easier

Bloomberg Businessweek offers an alternative take on the analysis of cash flows, both from the business’ and the investor’s points of view. Their methodology of reporting statements of cash flows provides investors with a more natural way to analyze the ways in which cash flows from investors, into and out of business activities, and then hopefully back to investors. The result is a cash flow statement which, while not perfect, allows investors to more easily differentiate between cash flows from investors and back to investors.

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