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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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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Right-Headed Investors Should Avoid Upstream MLPs

Summary

  • Over the last seven years, the majority of upstream MLPs have been unable to cover their investment and distribution costs through operating cash flows.
  • Upstream MLPs seems to be indicative of the broader upstream oil and gas industry with respect to investing and distribution/dividend coverage.
  • While some of the upstream majors appear to be fairly priced, high-quality independents tend to be over-capitalized, while under-capitalized firms tend to be of lower quality.
  • The majority of economic value in the oil and gas industry is realized further downstream.
  • Investors who insist on exposure to upstream oil and gas assets are likely better served by focusing on high-quality integrated majors.

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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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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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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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The Usual Suspects: A Preview of Sunday’s Investing Presentation

I am going to give a brief talk this Sunday as part of the brand new Meetup Group, Monterey Intelligent Investors. The details are as follow:

Sunday, August 4, 2013
10:00 AM to Cafe Lumiere
365 Calle Principal, Monterey, CA

Grading the Gurus
I have often wondered if it makes any sense to pay attention to investing gurus. I’m talking about the greats; the legends; the Warren Buffets; The Benjamin Grahams; those with real followings, real track records, and, most importantly, real philosophies. In brief, I want to ask questions and query data in such a way that will help people place the “usual suspects” into one of three groups:

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S&P 500 Historical Valuation

Dr. Robert Shiller is a leading authority on behavioral finance, a field that attempts to get at the heart of market economics. What’s at this heart? People, naturally. What’s the point? I argue that it behooves traders and investors alike to retain some degree of insulation from the general population’s view on value, and instead rely on a more rational definition of value. Schiller’s cyclically-adjusted Price-to-Earnings (CAPE) and Price-to-Earning-to-Growth (CAPEG) ratios are indeed very simple, rational, and hold a great degree of predictive power.

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