What’s Your Oil Company Worth?
Understanding the Standard Measure
There are a number of important metrics that go into determining a fair value for an oil and gas company. Near the top of the list is the value of its oil and gas reserves. There are plenty of other considerations — such as quality of management, geographical locations of the reserves, level of debt, and success at replacing reserves — but without a good metric for comparing the proved reserves of different companies we would be flying blind.
The Securities and Exchange Commission (SEC) requires oil and gas companies to estimate the year-end value of their proved reserves in the annual 10-K filing. Recall that proved reserves can be either proved developed (PD) or proved undeveloped (PUD) — and both are used in this yearly calculation. PD means the resource can be produced with existing or minimal investment, while PUD may be booked as “proved reserves” if the development plan for those reserves provides for drilling within five years.
The calculation required by the SEC is called the “standard measure,” and is the value of the proved reserves after production and development costs and future tax obligations have been deducted. Most companies also report something called a PV10, also sometimes called “future net revenues,” in which future tax obligations have not been deducted.
This 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.)
But the standard measure allows for a more apples-to-apples comparison between companies. The way this is calculated is that companies estimate the relative percentages of oil, natural gas, and natural gas liquids in their proved reserves and then make some pricing assumptions about each of these fractions. Finally, future net cash inflows are discounted using a 10% annual discount rate to arrive at a final value.
Obviously the pricing assumptions that go into these calculations are critical. If prices change substantially relative to the assumptions made, or if a company’s production and development costs are different than projected, this will change the standard measure calculation.
For example, if oil prices fall sharply and a company becomes unable to justify the five-year development timetable then it may be required to reduce its reserves estimate. This reduction in proved reserves can occur even if though the resource still exists. But the reverse is true as well. Sharp increases in price can cause some resources to be moved into the reserves category.
An Example
As an example, let’s take a look at the discounted future net cash flow for ConocoPhillips (NYSE: COP) for 2013:
ConocoPhillips’ discounted future net cash flow. Source: company 10-K
The calculation shows that the net future value of the company’s global reserves was $77.5 billion at the end of 2013. The company’s current Enterprise Value (EV) is $103 billion, which is just slightly ahead of where it was at yearend. But note the assumptions that go into the calculation. From the document:
“Twelve-month average prices are calculated as the unweighted arithmetic average of the first-day-of-the-month price for each month within the 12-month period prior to the end of the reporting period. For all years, continuation of year-end economic conditions was assumed.”
For most of the company’s global operations, the average price for crude oil was over $100 per barrel (bbl). The company notes the following sensitivities to oil and gas prices:
ConocoPhillips’ income sensitivity to commodity prices. Source: 2014 company presentation
With global oil prices down some $30/bbl since the end of 2013, it’s clear that the impact of lower oil prices on the annual earnings is around $5 billion. This trend will lower the discounted future net cash flow of most oil companies (which is also affected by changes in production), and it may result in reductions of proved reserves for some companies at year end.
Conclusions
While oil stocks have taken a beating since the summer, the extent of the losses varies greatly. Our goal is to find those that have been disproportionately and unfairly discounted relative to competitors. One way to compare companies is to look at their standard measure value relative to the enterprise value, the sum of market capitalisation and net debt. In the next Energy Strategist, I will be comparing a number of smaller oil and gas companies using such a measure.
(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)
Portfolio Update
SunEdison Bears Gone With the Wind
They don’t call it a windfall for nothing. SunEdison’s (NASDAQ: SUNE) transformative $2.4 billion deal for wind power developer First Wind blew out the short sellers with a 29% share price gain the day after the Nov. 17 announcement.
Actually, SunEdison’s cash outlay on the deal will total just $696 million, with another $340 million of the purchase price accounted for via a seller note — essentially an IOU from SunEdison. SunEdison is also on the hook for a $510 million earn-out based on the wind portfolio’s subsequent performance. Its yieldco subsidiary TerraForm Power (NASDAQ: TERP) is supplying the remaining $862 million of purchase consideration.
TERP’s immediate acquisition of 521 megawatts of First Wind’s generating capacity boosts the its forecast 2015 dividend 44%, for a yield of 5% based on the pre-deal price and 4.1% following that stock’s 24% subsequent rally.
SunEdison expects to leverage its relatively modest initial cash outlay into $5.7 billion of long-term value via profits and incentive distribution rights from First Wind’s remaining 1.6 gigawatts in backlog and pipeline projects.
Effectively, the company is engaged in asset arbitrage, buying renewable projects on the cheap-ish and selling them for a lot to investors in the TerraPower yieldco. Those investors care a lot about the tax-deferred yield and not nearly as much about valuation or the debt taken on, apparently.
Analysts tripped over each other to laud the deal, with Deutsche Bank anticipating at least a 50% markup by SunEdison on the First Wind assets dropped down to TerraPower. These include wind generation projects from Hawaii to Maine with a particular concentration in the U.S. Northeast. In combination with SunEdison’s solar power projects, they are expected to make the company the world’s largest renewables developer.
The reception accorded to the deal illustrates the value of yieldcos to their sponsors, especially once the incentive payments start piling up in earnest in a couple of years. It is the reason we made SunEdison a Best Buy in the first place, and why we’re now raising the SUNE buy below target to $25.
— Igor Greenwald
Stock Talk
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