This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.
In this series, I'll explain how to analyze such companies, so that we can build on this knowledge in future articles to understand exactly why many oil and gas companies are overvalued. This will help you, the reader, to avoid making the same mistakes.
In part 1, I explained how to analyze the profitability of each well. In this article, I'll explain how to understand oil and gas reserves that belong to companies, as well as some of the major corporate level expenses.
Reserves
Oil and gas reserves indicate an independent evaluator's opinion of how much oil and gas companies that can extract from its lands. Most companies evaluate their reserves about once a year, and you can find details about the reserves in the company's annual information form on Sedar.
Oil and gas reserves are broadly broken down into 2 categories: Proved and Probable.
Unfortunately, reserves evaluators have no way of finding exactly how much oil and gas each well can extract. Instead, they rely on statistical methods to estimate how much oil is extractable. Since these are statistical measures, there isn't one number, but a range. The amount in the Proved category indicates the amount of oil and gas extractable with 90% confidence, while the amount in the Probable category indicates the amount extractable with 50% confidence. For example, if there are a million barrels of oil in the proved category, that means the evaluator thinks there's a 90% chance the company can extract a million barrels or more of oil.
Reserves are further broken down into subcategories: Developed producing, develeped non-producing and undeveloped.
Developed producing indicates the amount of oil and gas extractable from wells that have already been drilled, and is currently producing. Developed non-producing on the other hand, account for wells have already been drilled, but are not currently producing for one reason or another. Undeveloped reserves indicate oil and gas extractable from wells that haven't been drilled yet.
The reserves evaluation also includes an economic report that calculates the value of the reserves. For example, the report may say that the Net Present Value of the total proved assets are $500 million. The evaluator takes drilling costs and expenses into account to arrive at such numbers.
Unfortunately, we must view reserves evaluations with a critical eye. Reserves evaluators get paid by oil and gas companies, so oil and gas companies can exert pressure on the evaluators.
Oil and gas companies have a lot to gain from larger reserve evaluations. A larger evaluation bumps up their stock prices, and it allows them to borrow more money from the banks, since the banks look at the evaluations to judge their credit worthiness.
Facilities
To get a holistic picture of oil and gas companies, we should be mindful of all their expenses. One of the major categories of expenses concern their spending on facilities.
In part 1 of this series, we examined all the expenses that go into drilling and operating a new well. However, oil and gas companies also have to deliver the oil and gas to market hubs. To do so, they need to build a few things like pipelines and oil batteries
Companies that focus on natural gas also build their own gas processing plants that separate out different liquids from their gases, and this can cost a lot of money.
You can find the amount that a company spends on facilities in their annual financial statements. I find that companies typically spend between 10% and 50% of what they spend on drilling new wells, on building facilities.
Since you need to build facilities whenever you drill new wells, it may make sense to incorporate these expenses in well economics. The difficulty with this approach is that spending on facilities fluctuate a lot, so it's difficult to know exactly how much facility spend is required for each well. However, even a modest inclusion of facilities spend in our well economics result in significantly lower value for each potential well.
General and Administrative
When you read oil and gas research reports and meet with executives, hardly anyone talks about general and administrative (G&A) costs, but they should. Though these expenses are relatively small, they are still meaningful.
G&A costs represent the normal costs of running any business: office rent, accounting, salaries, etc.
G&A are more meaningful for small companies than it is for big companies. For big companies, G&A may hover around 5% of their revenue, while for small companies, it can go up to 10%.
Since no company can drill new wells without paying some G&A, it might make sense to incorporate them into well economics as well. This would have the same effect as increasing operating expenses. For example, if G&A costs came out to be 5% of revenue and oil price was at $100, that means G&A cost about $5 per oil barrel. We could increase operating expenses by $5 to calculate our new well economics. As you can imagine, this would also bring down the value of each potential new well.
Taxes
When you examine the financial statements of junior oil and gas companies, you'll notice something peculiar. You'll notice that hardly any of them pay any corporate taxes. That's because they have tax pools.
Oil and gas companies accumulate tax pools by recording larger than usual depreciation. Let me explain what depreciation is.
When you drill a well, you incur up front costs, say $3 million. However, since the well has a long useful life, as with many other big ticket items, the government lets you record the expense over time (e.g. $300,000 a year for 10 years) instead of recording it all at once (i.e. $3 million one time).
Companies normally want to depreciate their assets as fast as possible, as that means bigger expenses and lower profits. Lower profits lead to lower corporate taxes. If the profits go so low that they turn negative, corporations can apply the loss against future earnings to lower their taxes as well. Such accumulation of losses is called tax pools.
Knowing that companies want to accelerate the depreciation whenever they can, governments only allow them to depreciate assets at a certain speed (e.g. 10% per year). However, drilling certain wells allow companies to qualify for much quicker depreciation schedules than normal, which allow the companies to accumulate significant tax pools.
Eventually, if oil and gas companies make money from their wells, they'll have to pay corporate taxes on them. However, because they can use and grow tax pools, junior oil and gas companies can usually defer paying taxes almost indefinitely.
Putting It All Together
When I used to work at the hedge fund, we used very sophisticated models and proprietary data to come up with a fair value for oil and gas companies. In this article, however, I'd like to propose a quick and dirty model. It goes like this.
- Cross check the reserves with production to data to make sure it's reasonable. If it is, take the NPV of the reserves, but adjust it down for G&A.
- If possible, cross check the type curves of each potential new well against production data to make sure they're reasonable. If it is, take the NPV of each potential well, and adjust it down for facilities and G&A.
- Calculate the following: Value of the company = (NPV of reserves) + (Number of potential wells) * (NPV of each potential new well) + (Cash and receivables) - (Current liabilities and debt)
Using these steps, we can get a ball park estimate of a company's worth, and use it to find cheap companies. In the next part of this series, I'll show you a real example of applying such an analysis.
This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.
