O&G - Valuation

Question 1

How do you calculate Equity Value and Enterprise Value differently for a natural resource company?

Answer 1

Equity Value is the same: take the common shares outstanding, add in dilution from options, warrants, convertibles, RSUs, performance shares, and any other dilutive securities, and multiply by the current stock price.

Enterprise Value is similar: start with Equity Value, subtract cash and cash-like items, and add debt, preferred stock, non-controlling interests, unfunded pension obligations, and similar liabilities.

But there are 2 new potential additions:

• Net Value of Derivatives: For companies that use hedging and therefore carry derivatives on their balance sheet, the net value of the derivatives might count as a cash-like item to be subtracted.
• Asset Retirement Obligation: This is a new type of liability that’s specific to natural resource companies – it reflects the cost required to shut down mines, oil fields, and wells in the future, discounted to its present value. You might add this as a debt-like item.

Please note that these two items are not universally added to calculate Enterprise Value – some banks count them and some do not.

Question 2

How is an oil & gas company’s capital structure different from a normal company’s capital structure? What impact does that have on the valuation?

Answer 2

Generally, oil & gas companies carry significantly more debt than “standard” companies in other industries like technology. They may have over a dozen different tranches of debt, often in the form of high-yield debt with bullet maturity.

They do this because they constantly need to find and acquire new reserves, and they may not always have sufficient organic cash flow to do so.

This difference doesn’t directly impact the valuation, but it’s one of the reasons why P / E multiples are not as meaningful for natural resource companies: a higher-than-normal interest expense can distort what P / E tells you.

Question 3

How are comparable public companies (public comps) and precedent transactions (M&A comps) different for natural resource companies?

Answer 3

The mechanics of picking similar companies and transactions and then using the median (or 25th percentile, or 75th percentile, or whatever you want) multiples to estimate value for the company you’re analyzing are the same.

The differences:

• You might screen based on Proved Reserves or Daily Production rather than traditional metrics such as revenue or EBITDA.
• You would list metrics such as Proved Reserves, Daily Production, the Reserve Life Ratio, and EBITDAX rather than traditional ones like revenue, EBIT, or EBITDA.
• You use multiples such as EV / EBITDAX, EV / Proved Reserves, and EV / Daily Production instead.

Note that once again, EBITDAX is not a universal standard – outside the US it isn’t necessary most of the time, and even in the US many banks still just use EBITDA.

Question 4

Let’s say that one of my public comps has a Reserve Life Ratio of 15 and another has a Reserve Life Ratio of 10. Which one will have higher EBITDA and EBITDAX multiples, and why?

Answer 4

All else being equal, the one with the Reserve Life Ratio of 15 will have higher EBITDA and EBITDAX multiples. Remember that the Reserve Life Ratio is Proved Reserves / Annual Production – a company with 15 rather than 10 can generate profits for a longer time period and may not need to explore and acquire as frequently.

Investors would reward that by valuing the company with the higher Reserve Life Ratio more highly.

Question 5

What are the flaws with looking at revenue and P / E multiples for natural resource companies?

Answer 5

Revenue multiples make little sense because revenue is almost completely dependent on commodity prices: rather than reflecting how much the company is producing or expanding, revenue multiples usually just reflect prices for oil, gold, gas, etc.

P / E multiples are not accurate because natural resource companies because often have high interest expenses, high deferred tax numbers, and high non-cash charges such as DD&A and Impairment.

It’s not necessarily “wrong” to use these multiples, but usually EBITDA, EBITDAX, Proved Reserves, and Daily Production are preferred.

Question 6

What’s the normal range for EBITDAX, Proved Reserves, and Daily Production multiples?

Answer 6

This one is dangerous to answer directly because the range depends on the geography, the sub-industry, and the type of company you’re looking at. In the case of Proved Reserves and Daily Production, it also depends on the measurement units – MBOE? MMBOE? Bcfe? And it gets even more fun on the mining side.

If they really press you for an answer, just say that EBITDAX multiples are usually in the same range as EBITDA multiples for normal companies, around 5- 15x and more like 5-10x for natural resource companies.

The production and reserves-based multiples vary so much that you’re better off saying that it depends and avoiding a direct answer.

Question 7

Could you create a standard DCF for natural resource companies? How is it different?

Answer 7

You could still create a standard DCF, and it works almost exactly the same way. There are 5 potential differences to note:

1. You will have additional non-cash expenses (e.g. Asset Retirement Accretion) in addition to the standard ones like DD&A and Stock-Based Compensation.
2. You would use Daily Production, EBITDA, or EBITDAX for the terminal exit multiples rather than Free Cash Flow-based multiples.
3. For the Gordon Growth method usually you assume 0% long-term growth because oil & gas assets get depleted over time and there’s only a finite amount in the ground.
4. You could use the oil & gas industry standard 10% discount rate rather than calculating WACC.
5. For the sensitivity tables you would look at commodity prices as one of the variables rather than revenue growth or EBITDA margins; other variables might be the discount rate and terminal growth rate or terminal multiple.

Question 8

Walk me through a Net Asset Value (NAV) model.

Answer 8

In a Net Asset Value model, you assume that the company never increases its existing reserves – so there’s no additional CapEx over time and the company literally runs out of energy or minerals at some point in the future.

You create a NAV model with the following steps:

1. Pick a starting number for the Reserves – usually this will be Proved Reserves (1P), but you could also go with 2P or 3P in more aggressive models.
2. Project Production and Realized Prices. Usually you assume that Production grows for a few years and then declines as the Reserves go to 0; Realized Prices are usually held constant in future years and are tied to historical averages.
3. Project the Production and Development expenses and Taxes to calculate After-Tax Cash Flows. Tie the Production expenses to historical averages on a per unit basis; you can find estimates for future Development expenses in the company’s filings. After-Tax Cash Flows = Revenue – Production – Development – Taxes.
4. Calculate the Net Present Value of the After-Tax Cash Flows. Use the NPV function in Excel and your discount rate, normally 10% for oil & gas.
5. Add the value of undeveloped land and the value of the other business segments such as chemicals, midstream, and downstream. You can estimate these with simple EBITDA multiples based on comps for each segment.
6. Work backwards to calculate Equity Value (i.e. add cash, subtract debt, and so on) and calculate the per share price.

It’s similar to a DCF but there’s no Terminal Value, which is arguably a good thing, and there’s a much smaller CapEx expense since you assume no future expansion.

Question 9

What’s the advantage of a NAV model over a traditional DCF?

Answer 9

There are 2 big problems with a DCF for an E&P-focused company:

• A DCF values a company at the corporate-level, but natural resource companies are balance sheet-centric and should be valued based on their assets instead.
• Natural resource companies often have extremely high capital expenditures that reduce their Free Cash Flow and may even make it negative; this distorts a traditional DCF and sometimes turns it into nothing more than a simple Terminal Value calculation.

A NAV model gets around those problems by valuing the company on an asset- by-asset basis (the producing assets are valued first, followed by undeveloped land and then other segments such as chemicals and midstream) and by eliminating growth CapEx.

Arguably the NAV is more conservative than the DCF as well, since you assume that the company stops producing after a certain point in time rather than the constant growth implied by a DCF.

Question 10

Let’s say that my NAV model is producing values that are far too low – which variables and assumptions should I tweak to boost the valuation?

Answer 10

1. Use Proved + Probable Reserves (2P) or Proved + Probable + Possible (3P) rather than just Proved Reserves.
2. Assume higher Production numbers in the earlier years.
3. Make more aggressive assumptions for Realized Prices – but be careful that they’re still in line with historical numbers.

Of these, #3 is the most problematic because companies have no control over commodity prices – so it’s better to start with the first two.

Question 11

Normally we prefer a NAV to a DCF, at least for E&P-focused companies. But what are some of the flaws with the NAV model? Are there certain types of natural resource companies where it doesn’t apply?

Answer 11

You could argue that a NAV model has similar problems to a DCF because you’re still projecting numbers far into the future, which is inherently unreliable
– and variables like commodity prices are almost impossible to get right.

You’re often projecting even further into the future than with a DCF because a company’s reserves might last for 10-20 years – so it might be even more dependent on far-in-the-future assumptions.

Also, a NAV model would not work as well for non-E&P-focused companies such as oil and gas transportation or refining firms, or oil field services companies.

They are not asset-centric and operate more like normal companies, so a traditional DCF is better there.

Question 12

How is a NAV model different for mining companies?

Answer 12

It’s the same idea, but you might have to go through a few more steps to project revenue – remember that mining companies extract tons and tons of minerals from the ground but are only able to use a small fraction. So you would have to make extra assumptions for the usable percentage.

Question 13

Why do we only subtract out Production and Development expenses in a NAV model – isn’t it inaccurate to skip over G&A and other expenses like DD&A?

Answer 13

You leave out expenses such as G&A because those are considered corporate overhead, and you are valuing the company strictly on an asset-by-asset level.

Some expenses are ambiguous – for example, sometimes you’ll see Taxes and Transportation subtracted out on the argument that they’re linked to production from individual assets.

But that’s the reasoning behind it – when in doubt, look at the “mini-NAV” that companies have in the PV-10 section of their filings and see which expenses they have subtracted.

Other expenses like Depreciation, Depletion & Amortization are not included because they’re non-cash in the first place and would therefore be added back even in a traditional DCF. You’re also not assuming any growth CapEx so you don’t want to include matching DD&A.