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. 

Summary

  • 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
February-22-Hogue-1937-Pecos-AOGHS
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

Summary

  • 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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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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