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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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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