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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Dropping It Like It’s (Not That) Hot: VLO’s MLP strategy in focus

Summary

  • Valero Energy Corporation’s (VLO) conservative valuation reflects a history of and expectations for cyclical margin pressures, secular regulatory pressures, and a management regime which does not create excess long-term shareholder value.
  • Management has singled out asset drop-downs to company sponsored MLP, Valero Energy Partners (VLP), as the most promising avenue for unlocking shareholder value.
  • Although the value gap between VLO and VLP is real, unless management radically accelerates VLP’s financing trajectory, the drop-down strategy will not significantly drive excess returns for VLO shareholders.
  • Disproportionate focus on arbitraging market value dislocations could detract from more enduring drivers of long-term value such as distressed asset acquisitions and continuous rationalization of core refining and logistics assets.
  • VLO’s core refining assets are among the best positioned and most complex in the world. If competently utilized, these assets are worth significantly more than the company’s market capitalization.

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VLO Is Conservatively Valued

Summary

  • Valero (VLO) is conservatively valued on an absolute basis according to a Discounted Cash Flow Analysis.
  • VLO is conservatively valued on a relative valuation basis against its peers group.
  • Conservative valuation reflects expected margin contraction. Even though analysts’ 2015 earnings estimates are still biased high, ample margin of safety makes VLO a long-term HOLD.
  • If/when estimates do come down, VLO is a BUY on the dip.
  • Although good things are more likely to happen to conservatively valued stocks, a separate thesis is needed to indicate how management would unlock value.

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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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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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Kingold Is Precious: Shares Up 40% Following Downgrade By Analysts

On Monday, 23 September 2013, “Kingold Jewelry (NASDAQ:KGJI) was downgraded by analysts at Thomson Reuters/Verus from a buy rating to a hold rating”, according to Zolmax News. The shares closed at $1.73 on Thursday 26 September, up 25% on the day, and up 40.6% from Monday’s close of $1.23.

These kinds of anomalies are pretty rare; living proof of the fallacy of instantaneous market efficiency. But as a wise woman once said, contradictions do not truly exist; “Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong” (AR).

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Yongye (ticker: YONG): A unique risk-arbit​rage opportunit​y

A lone Chinese female investor, Xingmei Zhong, d.b.a. Full Alliance International Ltd., finalized its plan to buyout all outstanding shares of YONG for $6.69 per share in cash. The deal is expected to close at the end of the first fiscal quarter of 2014 (i.e., between October and January). The buyout price reflects a 40% premium to YONG’s market price ($4.79) as of the date of the announcement on 12-Oct-2012.

At $6.25 per share, the buyout represent a 7.04% premium to market price. Investor’s looking for a relatively low-risk return on investment can engage in a risk-arbitrage trade. Investors can buy YONG now and will likely realize the differential between market and buyout price within 3 to 6 months. At the present, one could realize a 29.18% annualized return if the deal executes in 3 months; 14.20% if the deal executes in 6 months.

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Yeah, man, that pretty much sums it up

I have had several people already say to me that I am giving away too much information about how to profit in the market. If they mean that I have not been concise enough, duly noted. I must work on expressing myself more clearly.

If, on the other hand, they mean that I am giving away too much intellectual property without payment, then my response is that I have said nothing new. If sharing out the truth made it any less potent, then no one acting on publicly held information could conceivably earn returns above the amount of assumed risk. This is not true for the following reasons:
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Grading the Gurus

FORWARD REMARKS
I used to think of myself as contrarian, but after completing my most recent research project, “Grading the Gurus” (which I presented at the last MBIIM) , I now realize that I only appear to be a contrarian. I’ll spare you the discourse on how I came to that for now, but I’ll make sure to include it in my closing remarks.

For those who were unable to join us last Sunday, I thought I would summarize the presentation and the following discussion. Without further ado…

INTRODUCTION TO ‘THE PROBLEM’
Like my previous post says, “I have often wondered if it makes any sense to pay attention to investing gurus.” And there certainly are a lot of them. Most of which seem to promise you that they’ve found the “secret” to easy money, whether that be a method of valuing companies or assessing the market’s future direction. However, evidence suggests otherwise as it has been proven that 85% of mutual funds have underperformed “dumb” index funds over the last 40 years. This means that all those fancy folks that went to fancy schools and wear fancy neckties are not as smart as “passive” investors. Therein lies the problem…

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