Valuing an Oil and Gas Company

In the previous Energy Strategist I wrote an article — Potential for Mischief —  in which I discussed the difference between proved reserves that are reported to the U.S. Securities and Exchange Commission (SEC), and estimates of potential resources that are often presented to investors. The gist is that the latter is often many times higher than the former. This is not surprising, as the standards for reporting proved reserves require that there is a plan to develop them within five years, while a company may hold resources that it will ultimately develop but that don’t qualify as proved reserves under the SEC definition.

It is hard to tell whether a company might be exaggerating its potential resources, and if so by how much. Companies are protected by the Private Securities Litigation Reform Act of 1995, which provides a “safe harbor” for some forward-looking statements, and therefore they have some protection should their estimates of potential resources ultimately prove to be too optimistic.  

The value of a company’s oil and gas reserves is obviously a critical factor in assigning a value to the company, but this is complicated by companies potentially exaggerating their resources. In this case, two considerations are important. The first is whether the company has a history of backing up its statements. For example, Conservative Portfolio holding and current #5 Best Buy ConocoPhillips (NYSE: COP) is a company that lists proved US reserves of 712 million barrels of oil equivalent (MMBOE), but 3,100 MMBOE of resource potential. Given the company’s history in recent years of delivering on forecasts, I put more stock in this projection than in those of some of the smaller players without the same track record.

But beyond trusting management, we can attempt to compare companies by estimating the value of their proved reserves. This is an imperfect method, because there can be a wide variation in production costs. The realized prices of natural gas, natural gas liquids (NGL) and oil are similarly crucial to these calculations, and these prices change from year to year. The mix of gas, NGL and oil in a company’s proved reserves also matters.

In the previous Energy Strategist, Igor Greenwald attempted to value the reserves of Aggressive Portfolio holding Emerald Oil (EOX) in A Gem Priced as Zirconium. This week, I am going to apply a similar approach to the 15 companies with the largest U.S. oil and gas reserves. I will compare this value to the company’s enterprise value (EV), taking into account the different values for natural gas, NGL, and crude oil in a company’s reserves.

The PV10

I used my own calculation of a metric called the PV10, which is the present value of estimated future oil and gas revenues based on proved reserves (developed and undeveloped) minus estimated direct expenses, discounted at an annual discount rate of 10%. The lower the EV/PV10 ratio, the cheaper the value of the company relative to its future cash flows. An EV/PV10 of less than 1 implies that the shares are cheaper than the value the company will deliver over time based on the PV10 calculation.

Oil and gas companies report PV10s in the 10-K form that they file with the SEC (which is sometimes labeled “Future Net Revenues”). However, sometimes they only report the value after future tax obligations have been deducted (a value required by the SEC and known as the Standard Measure). The pre-tax PV10 is a non-GAAP measure, and so there can be differences in how different companies arrive at their conclusions. (GAAP stands for generally accepted accounting principles, the most formal and inflexible set of rules for assessing a company’s finances.)

These PV10s can include foreign reserves as well, but I was interested in the value of U.S. reserves. So I calculated my own standardized pre-tax PV10 for each company. I did this by looking at the various commodity margin variables companies used to calculate their own pre-tax PV10s, and then applied a standardized set based on these to all 15 companies. For this exercise, the values used were $20/bbl for oil, $7.50/bbl for NGLs, and $0.73/thousand standard cubic feet (MSCF) of natural gas. Think of these numbers as the margins per unit of reserves after certain expenses have been paid, with future cash flows discounted at an annual rate of 10% (the industry standard).

Of course not all companies have the same operating costs. There can be a substantial difference across companies. Thus, the PV10 that I calculate will be more representative of an industry average. However, when I applied this formula to companies with reported pre-tax PV10s, the numbers I calculated were pretty close to those reported.

Looking at the case of Emerald Oil that Igor examined in the previous issue (but not one of the 15 companies in my analysis), the reported PV10 is $289 million while my calculated PV10 for Emerald Oil using my general formula was $271 million — a variance of just over 6%.

Comparing the Top 15

The results of my own analysis are shown below, sorted in order of the size of each company’s proved U.S. oil reserves. This is an important caveat, as some of the companies listed have significant proved reserves outside of the U.S., and they have higher EV/PV10 ratios that reflect these additional reserves.


Proved US Reserves = million barrels of oil equivalent (MMBOE) located in the U.S.
Potential = MMBOE of U.S. potential reserves presented to investors
Ratio = Potential/Proved (which could indicate how much a company is exaggerating)
Gas = Percentage of the proved reserve that is dry natural gas
Liquids = Percentage of oil plus natural gas liquids (NGLs), also individually shown
EV = Enterprise Value in billion dollars on 11/5/2014
Sum = the total value of the oil, gas, and NGL columns for each company in billions of dollars using $20/bbl for oil, $7.50/bbl for NGLs, and $0.73 per million standard cubic feet (MSCF) of natural gas

There are several things to note about the data. The first is that all else being equal, EVs for liquids-rich companies should be higher than those of gas-rich companies, because margins on oil have been better in recent years.

Second, several of the companies with the highest EV/PV10 ratios — such as Noble and Apache — do have significant international reserves. Devon Energy (NYSE: DVN), for example, has reserves in Canada. Adding in the value of Devon’s Canadian reserves drops the calculated EV/PV10 ratio from 2.18 to 1.58. So a high EV/PV10 isn’t necessarily cause for alarm, but it does merit additional investigation.

WPX Energy (NYSE: WPX) appears to be the cheapest company listed, with an enterprise value barely above the present value of the profits it expects to realize from its reserves. Chesapeake Energy (NSYE: CHK) and Continental Resources (NYSE: CLR) also look relatively cheap by that measure.

On the high end, Cabot Oil & Gas (NYSE: COG) stands out since it has no international reserves and yet has a comparatively high EV/PV10 ratio of 3.2. This requires an additional level of inquiry before we could conclude that Cabot is overvalued according to this metric. What we find is that Cabot is one of the lowest cost producers in the Marcellus (and likely the lowest cost producer), so it realizes much more than the $0.73/MSCF for natural gas that I used in my analysis. In fact, Cabot’s internal PV10 calculation for year-end 2013 resulted in a value of $6.5 billion, implying the company used ~$1.13/MSCF for its calculation. Cabot’s PV10 calculation would give it an EV/PV10 ratio of 2.2.   

The inverse is of course true as well. A company could realize lower margins than the assumptions I used in my analysis, which could justify a low EV/PV10. The way to check that is to determine whether the company has released its own PV10s and cross-check.

Conclusions

The purpose of this exercise was to identify companies that appear to be trading higher or lower than their peers based on the present value of proved reserves. However, this only serves to identify promising candidates for additional due diligence. Consider this the first level of analysis to highlight companies that stand out. In the case where a company has a low EV/PV10 multiple, we have a candidate for further research.

In the next Energy Strategist, I will analyze EV/PV10s for a number of companies based on the PV10 values they provided the SEC at year-end 2013.

Today’s exercise focused on U.S. reserves. This is fine if you are interested in pure play U.S. producers. But in the next issue I will delve into the PV10 comparisons for companies that in some cases have a large portion of their reserves abroad.

One extremely important caveat is that the value of proved reserves, and therefore the PV10, depends on oil and gas prices. This year’s PV10s may be lower than year end PV10s for 2013, depending on the price assumptions each company uses and whether its production outlook has changed significantly.  

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