A Guide to Oil & Gas Company Valuation: What's the Drill Bit Worth?

Valuing oil exploration companies is quite tricky. You're valuing possibilities and probabilities, rather than actual resources; and there's no one way of doing it, but rather quite a few different approaches. Even where a Competent Person's Report (CPR) gives you most of the data on resources, you need to be able to take your own view on what the resources are actually worth.

I'm going to run two articles on this topic. This first one is about how oil exploration companies develop and what resources and reserves are all about. Then in the second one I'll go into more detail about how to value those reserves. I'm not going to go into detail about 1P, 2P and so on - you can learn about these once you've got the hang of oil investing. What I'm going to try to do is to explain how oil exploration works, and how the valuation tracks the development of the company.

First let's look at how an oil company develops over time. Of course an oil company doesn't have to start at the point of buying unexplored or undeveloped licences - it could farm in to a prospect at a later stage, or buy a smaller explorer. Increasingly, companies are buying up acreage that wasn't developed in the 1980s (when the oil price was much lower than today) and going back to take a second look. But for the sake of argument le's start at the beginning with a licence. Obviously not worth zero, but you have no way yet of telling how much oil is there. The process from here on is about assessing, with gradual refinement and increasing certainty, what is there. You start with a geological overview - what fields are close by? Are they productive? Are there particular problems such as heavy oil, the need for fraccing, difficult access? That all gives you a rough feel.

Then the company will use 2D and 3D seismic, and that gives an overall feel for what's in this particular licence area. Next, drilling - using the seismic data the company will aim to drill where it expects the reservoir to be, and will then drill further wells to attempt to outline the size of the reservoir. Once there's been some drilling, and discoveries have been made, a proper reserve figure can be arrived at. Look at TV programmes and you'd think it's about finding a 'gusher' - it's much more complex than that. The logs need to be analysed to see where the oil is, and what kind of oil it is, and this data put together with the rest to see if it gives useful information on the rest of the geology.

So gradually, we're approaching knowing how much OOIP (original oil in place) there is. But some of that oil will be recoverable - some will not. So it's not a particularly useful number for valuation purposes. Equally, some of the recoverable oil might be only technically recoverable - you can get it out, but it will cost so much to do so that it's not worth doing.

We need to look at how much of it economically recoverable - that is, at a given oil price, it's worth actually recovering it. And it's at that point that the oil can be formally identified as a reserve. At each stage of exploration the company is involved in 'proving up' or 'derisking' its reserves. If for instance we have a second well drilled, and it finds oil not far from the first, successful, well, then we have reduced the risk. That makes the reserve more certain. But of course if the wrong results come in - a well failure might mean the reservoir can only be half as big as was expected - then reserves numbers can shrink, as well as grow. So that's a risk, even if you're paying close to the value of the oil that's proven so far.

There's also production risk. A well can go into production and then suddenly start to had problems - lower rates of flow, perhaps reflecting water penetration. Again this might affect the amount of oil that can actually be extracted. So at no point is there an absolute end to risk. There is always some risk with an oil company - it just ought to get less over time.