O&G - High Level Flashcards
How are energy and natural resource companies different from normal companies?
• They Can’t Control Revenue: More accurately, they can’t control the prices they receive for their “products” (oil, gas, gold, etc.) and can therefore only control the production side of revenue.
• Asset-Centric: All value for natural resource companies flows directly from their assets – how much in reserves they have in the ground, how much they can produce, and how much they can find to replace what they’ve produced.
• Different Accounting: There are different accounting standards, more so
for oil & gas companies, and so you have to do extra work when modeling companies and when using them in a valuation.
• Depleting Assets: When natural resource companies produce energy or
minerals, they also deplete the PP&E on their balance sheets – so they have to spend a small fortune on finding or acquiring replacement assets.
• Cyclical: Prices for commodities such as oil and gold are cyclical and
therefore difficult to project – to get around this, you have to look at longer time horizons and use price scenarios in models.
What are the different segments of the oil & gas and mining industries?
The major segments for oil & gas are upstream (also known as Exploration & Production (E&P)), midstream, downstream (also known as Refining & Marketing (R&M)), oil field services, and integrated majors.
Most M&A activity takes place in the upstream segment because those companies focus on finding and producing energy in the first place, which is the biggest value driver in the industry.
Midstream companies store and transport energy via pipelines and land, sea, and air transportation, and downstream companies turn energy into products that are usable by the consumer, such as jet fuel or automobile gasoline.
Oil field service companies provide drilling, management, construction, maintenance, and other services to energy producers.
Integrated majors (Exxon Mobil, BP, etc.) operate across multiple segments – so they might have both upstream and downstream segments, for example.
Do these other segments outside of upstream still share the same differences compared to normal companies?
No, not to the same extent. Everything is sensitive to commodity prices, but other areas such as downstream, midstream, and oil field services are much closer to “normal” companies because they are not as asset-dependent as upstream companies.
For the integrated majors, normally you analyze each business segment separately – so an upstream division would still have the same differences, but the downstream and midstream divisions would not.
What are Production and Reserves and why are they so important for these companies?
Reserves are how much a natural resource company has in the ground that could potentially be extracted in the future. It’s important because everything in
models flows from how much they have in the ground, and it’s one of the key inputs for the Net Asset Value (NAV) model.
Production is how much the company is extracting and turning into energy or minerals – usually it’s listed on a daily basis for energy companies and on an annual basis for mining companies, though you see both methods used in filings.
Production is important because it’s the key driver for revenue and expenses in a model: for normal companies you might make revenue growth or profit margin assumptions, but for natural resource companies you make production growth, commodity price, and per-unit expense projections instead.
How are the 3 financial statements different for a natural resource company?
- Income Statement: Revenue is split into categories such as gas, oil, and downstream; COGS does not exist and all expenses are listed together; common expenses are Production (similar to COGS for normal companies), Taxes & Transportation, DD&A (Depletion, Depreciation & Amortization), Accretion of Asset Retirement Obligation, G&A, Leases, and Midstream / Downstream expenses.
- Balance Sheet: It’s almost exactly the same, but PP&E may be split into Proved Properties and Unproved Properties; on the liabilities side, the Asset Retirement Obligation is an industry-specific item that reflects the cost of shutting down wells and mines in the future.
- Cash Flow Statement: Very similar, but you add back new and slightly different non-cash expenses such as the Accretion of Asset Retirement Obligation and the Non-Cash Derivative Losses; under Cash Flow from Investing, you may project Asset Sales and Purchases since they’re recurring items.
How would you value a natural resource company?
You still use public comps and precedent transactions, but:
- You screen based on Proved Reserves or Production rather than the usual Revenue and EBITDA criteria.
- You look at metrics like Proved Reserves, Production, EBITDAX, and the Reserve Life Ratio instead of Revenue and EBITDA.
- You use valuation multiples such as EV / EBITDAX, EV / Proved Reserves, and EV / Production instead.
You could still use a DCF, and for segments outside of E&P it’s quite common because you can still project growth and cash flows.
For E&P, though, the Net Asset Value (NAV) model takes the place of the DCF.
You assume that a company produces resources until it literally runs out, and then make assumptions for the realized prices, expenses, and taxes to calculate after-tax cash flows; take the net present value of those and then add in the value of other business segments and undeveloped acreage to calculate Enterprise Value.
You use this methodology because a natural resource company’s value lies in its assets rather than the company as a whole, and because “Free Cash Flow” as defined in a DCF may be very low due to high CapEx.
What are common metrics and valuation multiples for energy and natural resource companies?
- Proved Reserves: How much in minerals/energy the company can extract with 90% certainty.
- Daily Production: How much in minerals/energy the company is producing each day.
- Oil Mix %: The percentage of Production or Proved Reserves that are oil rather than natural gas (you could make a similar calculation for mining companies).
- R / P Ratio or Reserve Life Ratio: Proved Reserves / Annual Production, in other words how many years until the company depletes its resources.
- EBITDAX: EBITDA + Exploration Expense, needed to normalize different accounting standards.
- EV / EBITDAX: How valuable is a company in relation to its approximate normalized cash flow?
- EV / Proved Reserves: How valuable is each unit of a company’s Proved Reserves?
- EV / Daily Production: How valuable is each unit of a company’s Production?
You could also use Annual Production rather than Daily Production, but daily metrics are more common for oil & gas companies.
Note that the last 2 multiples – EV / Proved Reserves and EV / Daily Production
– are in dollars per unit (or Euros, yen, RMB, or whatever the currency is) and are not actual numbers. A “multiple” there does not mean 2.0 x, but rather $2.50 or $10.15 (for example).
