How To Value Oil And Gas Shares
- P/E Ratio
- The PEG Ratio
- Price To Sales Ratio
- Price To Book Ratio
- Dividend Yield
- The Gordon Growth Model
- Discounted Cash Flow (DCF)
- Return On Equity and Return On Capital Employed
- How To Value Oil And Gas Shares
- How To Value Bank Shares
- How To Value Insurance Shares
- How To Value Property Shares
- Capital Asset Pricing Model
Here we look at some specific of valuing oil and gas companies, and the issues which arise from upstream, exploration and production businesses. The same approach also applies to mining companies, with a little change of terminology.
Selling fixed assets
The distinctive feature of natural resource companies is that they sell their fixed assets. Most companies sell current assets and buy more raw materials on a constant cycle, and so generate profits indefinitely.
But if an oil company has, say, ten years reserves of oil and makes no further discoveries, then its cash flow will dry up in ten years. So we need to pay particular attention to the replenishment of reserves in assessing a company’s value.
Costs incurred in exploration and development of new oil fields or mines are an important feature of the business. Broadly exploration costs are written off if unsuccessful and are capitalised, along with development costs, for successful discoveries.
Capitalised costs become the asset value of the new find in the company’s balance sheet. Natural resource companies charge depletion, as well as normal depreciation, to their profit and loss accounts. This is the using up of their reserves as they are extracted.
A bit of jargon
The oil and gas in the ground is classified according to the probability it can be exploited.
Reserves are oil and gas estimated to be commercially recoverable, i.e. both technically feasible and commercially worthwhile to extract. They are sub-divided into proven, probable and possible reserves according to whether they are at least 90%, 50% or 10% certain of recovery respectively.
Contingent resources are potentially recoverable deposits which cannot yet be commercially developed.
Oil is measured in barrels. Gas is converted into barrels of oil equivalent, boe, representing an amount of energy equivalent to a barrel of oil.
Conventionally the oil industry used a single m to denote thousands and a double mm to denote millions. Thus the standard measure of reserves, millions of barrels of oil equivalent, is the mmboe. Every industry has its mmboe jumbo!
Production is the rate of extraction, usually measured in barrels of oil equivalent per day, boepd.
The key factors which drive profitability are:
- exploration, development and decommissioning costs;
- production costs, per boe extracted;
- sales price, i.e. the oil price or commodity price; and
- finance costs.
The connection with sales price leads investors to buy gold mining stocks, for example, as a proxy for gold, though it is a moot point how correlated miners’ share prices and the underlying commodity truly are.
With one proviso, the standard P/E ratio is a good metric for this sector. Analysts also often compare EV/EBITDA ratios, as this eliminates differences arising from different depletion rates.
The proviso is that we also need to look at reserves and their depletion and replenishment. There are a number of approaches to this:
- Price/reserves: this is the market cap divided by reserves in mmboes using proven, or proven and probable, reserves. It is often cited in acquisitions and represents the price paid for each potential barrel of oil;
- Reserve replacement: new reserves added divided by reserves depleted. If this is greater than 100% then the company is adding to its reserves, and vice versa;
- Reserve life index: this is (proven) reserves divided by annual production, and so is an estimate of how many years life there is in a company’s reserves;
- Comparing EV/EBITDA to reserve life index. This is more relevant for small cap companies. If the market is ascribing a greater multiple to a company’s cash flow than it has years of production, then it must be making heroic assumptions about future discoveries.
The most important performance indicators are:
- Production, measured in boes;
- Production costs, measured in £/boe produced.
Return on capital employed is significant but because of the long term business cycle, it is better to look at several years’ averages.
Financial strength metrics
The gearing ratio and interest cover are important metrics.
It is worthwhile looking at the cash flow statement. Net cash flow from operating activities is misleading because these companies make profits from selling fixed assets.
It is better to compare net cash flow used in investing activities with net cash flow from operating activities. This tells you how much of the company’s investment in new assets is financed from its own operations rather than external financing.
Claim your FREE copy of The Motley Fool’s Bear Market Survival Guide.
Global stock markets may be reeling from the coronavirus, but you don’t have to face this down market alone. Help yourself to a FREE copy of The Motley Fool’s Bear Market Survival Guide and discover the five steps you can take right now to try and bolster your portfolio… including how you can aim to turn today’s market uncertainty to your advantage. Click here to claim your FREE copy now!