Some 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,