A Guide to Valuing Oil Companies (part 2)

Friday, Mar 12 2010 by

Valuing oil companies news story imageSome of the difficulties involved in valuing oil companies are because the company is always developing along the trajectory from 'we think there's oil there' to 'we know there's oil there and we can prove it'. As an investor, you're looking for the extra value - which might not be what the reserves are worth now, but what you think they'll be worth if three out of the next five wells hit oil.

Remember that reserve values can grow in two ways. First, the reserve can be increased if the company actually finds oil. But secondly, it can be increased if the certainty of the reserve (technically, the probability of extracting the oil - and that's where P1, P2, P3 come in) becomes greater.

So as an investor, you're looking forward to see if you can guess what's going to happen to those numbers. And you then have just the same problem as any other investor of working out what the market is discounting - for instance if your oil company has a one in ten chance of success, but the market is valuing it as if has a one in five chance, you're sunk. If the market reckons it has a one in twenty chance, you could do all right - though if it drills all duds, you're sunk unless you sold the stock first!

The easiest way to value a company is to look at 'oil in the ground'. That's really quite a rough figure as it doesn't account for how costly the oil will be to get out, and you have no idea sometimes how much of the total oil will be recoverable. However, what you do is to look at other companies at the same stage of development, and take the same valuation. You might decide to reduce it a bit if you think there's more risk. Conventionally that's quite often been three bucks a barrel - though that probably undershoots the value of oil these days by a considerable margin.

Oil analysts do a lot more work. They generally work out what the field might produce in future, building into their model specific flow rates, the decline in production after the field passes its peak, development costs and appropriate oil price forecasts. Then they discount this back to get a net present value for the field. That's a lot of spreadsheet - and it depends on detailed data that may not always be available to the private investor.
Now if this was a power station or a technology company, that NPV would be the value you'd want to work on. But because the field is still not producing, and the drilling programme might not be a success, analysts now risk the NPV. Basically, they're saying:

“This is what the field is worth if all the oil we think is there, is actually there. But we're only 40% certain so we'll discount it another 60% and that's what it's worth now.”

As you can see, the risked value is an 'as now' value, so you might be justified in paying a premium to NPV if you thought there was a good chance of that risk being removed in the short term. Equally, if you thought the analyst was being a bit bullish, you could justify paying a discount to the NPV.

It's important not to confuse this type of asset value with the asset value of, say, an investment trust or a property company. When we look at British Land Co Plc's NAV, we know the buildings exist and are rented out, we know the level of rental income they're producing, and the only variable that is likely to change much is the yield that's used to value the properties. (Okay, over time, incentives and falls in rental levels will have an impact - but that takes a while to come through.) The level of certainty applied in oil exploration is much less.

Now let's just introduce the fly in the ointment. With all this complexity, let's not forget that licences cost money, seismic costs money, drilling costs money - and all that money has to come from somewhere. So your oil explorer is likely to need to raise money - which means that NPV you've calculated will get diluted along the way, either by farm-outs (and that's a whole different subject) or by equity fundraisings. But that's a whole new issue...

Filed Under: Valuation,


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11 Comments on this Article show/hide all

Betasurfer 28th Mar '10 1 of 11

This article is ok, but a bit superficial. Extending things a bit deeper, can anyone recommend any really good introductory books on the E&P sector, with a focus on valuation? I am looking for something akin Michael Coulson's "The Insider's Guide to the Mining Sector" (mentioned here) which is excellent, i.e. things to watch for when investing in E&P shares?

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tournesol 28th Mar '10 2 of 11

Hi Beta

check your e-mail


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tournesol 28th Mar '10 3 of 11


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siestainvestor 4th May '10 4 of 11

It would be nice to have a simple (some will say superficial!) way of valuing oil companies.  Trading and manufacturing companies can be easily compared with PE ratios and PCF ratios etc which are well understood. 

It seems to me that with a smaller oil company you are buying a future income stream represented by reserves plus a bit for hope beyond that less some factor for cost of getting oil from the ground. 

A first order valuation assessment might therefore use a ratio of market capitalisation (in £m) to reseves (in mmbboe) - call it the PR ratio.  (I accept this ignores varying costs of production however one might argue that production costs are going to be attenuated within a range as otherwise it goes outside the economic).  This thought throws up the table below.

At first blush it looks like we should all be selling Cairn and buying Dana.

No doubt the more dedicated oil followers here will have a better idea.  If so, please make it an idea of some use to a lazy man.

Oilco MktCap Reserves PR ratio
Cairn 5612 342 16.4
Dana 1121 357 3.1
Soco 1347 143 9.4
Tullow 10171 894 11.3
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emptyend 4th May '10 5 of 11

No doubt the more dedicated oil followers here will have a better idea.  If so, please make it an idea of some use to a lazy man.

Hi Siesta,

I've previously used a related measure to work out how many 2P barrels of oil equivalent one is buying for each £1000 of shares. You should, however, adjust your measure for a couple of things:

a) net debt or net cash (taking the cash off in order to arrive at the Enterprise Value that relates to the reserves)

b) any material discovered but unbooked reserves (these are substantial in some cases!)

....and then you should carefully interpret the results, taking account of factors such as gas/oil mix in the reserves, political risk and the economic value of the reserves (which can vary substantially - eg gas in Siberia is worth very little, whereas oil in California is worth rather more!)

You also have to be absolutely certain you are comparing apples with apples. The Dana figure you quote above is most definitely NOT on the same basis as the SOCO figure (the SOCO figure is the 2P reserves, which are mainly oil....and the Dana 2P reserves figure is 223mn boe, of which only 140mn bbls is oil). If you additionally adjust for net cash then I suspect you would get very similar figures for Dana and SOCO on a 2P basis (though it is my belief that SOCO's total resources figure....which they don't publish....would in fact be considerably bigger than Dana's).


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tournesol 4th May '10 6 of 11

In reply to siestainvestor, post #4

Hi Siesta

1) the general direction of your thinking is sound but you are using the wrong denominator - market cap tells you nothing about debt/cash balances or the value of the business. You need to use Enterprise Value (EV) instead.

EV = market cap + debt + (minority interest and preferred shares) - (cash + cash equivalents)

2) You are using incorrect reserve figures for at least one of the companies you cite - do you undersand the difference between resources and reserves? and between P1, P2 and P3 reserves? Most analysts would use 2P reserves (aka proven + probable)

3) If you do this kind of ratio calculation you need to be careful about comparing apples with apples. Don't use one company's 2008 reserves vs another's 2009 figures, for instance.

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emptyend 4th May '10 7 of 11

two minds etc etc.....  ;-)

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repobear 4th May '10 8 of 11

In reply to Betasurfer, post #1

Hi Betasurfer,

I am looking for something akin Michael Coulson's "The Insider's Guide to the Mining Sector" (mentioned here) which is excellent, i.e. things to watch for when investing in E&P shares?

I don't think such a book exists. If it does it isn't required reading for analysts;-)

However I'm sure that the best commentators here, and on TMF, could put together a book fairly readily because they clearly have the knowledge, and writing ability to get a very good first draft together. A bit of help from a publisher and it would be a decent seller I would think.

I suspect that some companies that are closely followed here won't be around if it ever got published though.



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djpreston 4th May '10 9 of 11

ONe comment - why is the article/thread tagged with British Land?

Fund Management: European Wealth
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siestainvestor 4th May '10 10 of 11

emptyend and tournesol

I take the point about Enterprise Value. I said I was lazy!

I was taking reserves as reported in Annual reports as Net proven and probable and barrels oil equivalent for gas. I thought they were all 2009 figures. I also assumed there would be an accounting standard for such valuations and to this extent they were all apples.

I guess we are never comparing apples with apples as accounting is an art not a science.

The discovered but not booked component is difficult to capture as a simple figure. Likewise adjustments for distribution to market - I guess gas in Uganda is not hugely valuable either.

I'll go back to the drawing board.

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emptyend 4th May '10 11 of 11

In reply to siestainvestor, post #10

I was taking reserves as reported in Annual reports as Net proven and probable and barrels oil equivalent for gas.

You plucked the wrong figure out for Dana though!

I also assumed there would be an accounting standard for such valuations and to this extent they were all apples.

Well there are certainly a series of tests that are applied, so yes 2P barrels should be a valid point of comparison. However there remains the difference between high quality eating apples (oil) and lower-value apples for cider making (gas).....and, as Dana's "resources" number illustrates, there are often larger "possible" reserves that are not included in the 2P, because they have yet to be sufficiently proven-up.


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About Anna Morrell

Anna Morrell

Keen student of all things financial - always looking for fresh ideas in the markets, whether it be new stocks or innovative instruments.

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