Beyond the Barrel: Understanding Valuation Metrics in Oil & Gas Deals

This article was written by Abraham Turpen and Bart Vermeulen during their tenure at the Falcon West Academy, Group 2

Valuation in oil and gas deals is unique due to the industry's complex price and cost volatility. The nature of these projects requires high capital expenditure and long lead times before any net positive cash flow can be reported. Forecasting future cash flows, estimating reserve quality, and ensuring successful drilling all pose significant hurdles for accurate valuation. Oil and gas valuation isn't just about financial statements; it requires in-depth knowledge of geology, engineering, commodity markets, and the regulatory environment.

Oil and gas production is divided into three parts: upstream, midstream, and downstream. In this article, we'll focus on upstream oil and gas companies, often referred to as E&P (Exploration and Production) companies. We'll explore common valuation models and highlight how they can potentially misrepresent asset value.

Discounted Cash Flow (DCF)

E&P company valuations are often determined by calculating the fair value of a company's oil and gas reserves, in addition to the value of net assets on its balance sheets. To estimate reserves, independent engineers provide a reserves report, which details the expected gross production from wells. Using this data, we have a starting point to build our DCF model. Next steps include subtracting any payments due to mineral rights owners, estimating future commodity prices, and estimating operating and capital expenditures. Future values in these reports are typically discounted 10-25% (Khetan & Yahya, 2016).

What are some concerns to consider when using a DCF model to value E&P companies? We had the same question, and a couple of points stood out. Firstly, what commodity price forecasting tools are used, how accurate are they, and are there any hedging strategies in place to minimize potential financial losses? Secondly, are the projected volumes of production consistent with historical production? Finally, are the asset retirement obligations and associated costs taken into consideration?.

Net Asset Value (NAV)

Net Asset Value differs from traditional valuation because it doesn't assume perpetual growth. Instead, it only considers the present value of all future cash flows tied to the well, then adjusts for other liabilities and assets on the E&P company's balance sheet. By using reserve reports for total production, gathering accurate price assumptions, and projecting future production decline rates, E&P companies can estimate year-to-year gross revenues. After deducting operating and capital expenditures, you're left with free cash flow from operations, which is discounted to its present value. The company would then add its net assets to this present value of free cash flow, resulting in its Net Asset Value.

A well-thought-out and meticulous NAV model is an extremely valuable tool because of the asset- centric focus of E&P companies. It also allows for sensitivity analysis when dealing with volatile commodity prices, which can be troublesome for other valuation models. The main issue with the NAV method is its lack of accounting for future growth. Within the industry, there's constant new exploration and acquisition that can lead to significant growth on the balance sheet. This can limit and undervalue companies that aim to reach new areas and develop new wells. NAV also doesn't account for a company's equity structure or financial leverage, both of which play a huge part in valuation.

Market Approach

The market approach to valuing E&P companies is generally appropriate. A market approach valuation uses similar publicly traded companies or other publicly available data from M&A transactions to value a company. Unlike other sectors, E&P companies typically have exploration costs they must take into account. Hence, for market approach valuations, analysts use EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization, and Exploration costs). This way, the project is valued on its production (earnings) while considering operating and capital expenses.

Some considerations to keep in mind for the market approach are:

Company size: The companies in the market that you compare this company to must be of similar size, whether that's by market capitalization or reserve volume.
Commodity mix: Oil and gas reserves can have different ratios. If you're comparing reserves with 70% oil and 30% gas, the other companies' reserves should have comparable ratios for the valuation to be accurate.
Reserve life: Also known as the 'reserves-to-production ratio,' this is the proved reserves (oil in the well) divided by the amount produced in the previous year. This provides a time estimate, which plays an important role in the valuation of a project; the longer the well can produce (at a constant volume), the more valuable a well site/project will be.
PUDs / Proved Reserves: The ratio of proved undeveloped reserves (PUDs) to proved reserves gives us an indication of how much of the total reserve base is currently generating EBITDAX. Therefore, a project with a higher ratio has the potential to increase production, and with larger reserves, it may have a higher valuation.
Areas of operation: For example, to compare a company/project to others in the market, they should have similar geographies and operational challenges that may be associated with those geographies.
Current data: Forward or current year data for reserves, production, and EBITDAX is required for the market approach. These valuation indications can be affected by the frequency of reserve acquisition and divestitures among publicly traded E&P companies, resulting in time-consuming research of publicly released information to generate an accurate valuation.

Conclusion

We wondered why the DCF model is the most popular method in the industry; therefore, we studied and reviewed the three most common valuation models for upstream oil and gas companies. Even though the DCF model requires some assumptions, the data appears more robust, and the number of considerations are fewer than with other valuation methods. The NAV's primary shortcomings are its inability to take into consideration future growth in an industry that relies on exploration and the production increase in oil and gas. Moreover, the model also doesn't account for a company's equity structure or financial leverage.
The market approach method aims to use existing market data to value a company. However, in this industry, there's too much variety in size, production capabilities, reserves, geographical challenges, and robust data. The sheer number of variables to consider to create an accurate valuation makes the DCF model far more simplistic and accurate.

Therefore, despite having its own challenges, the Discounted Cash Flow Method is the most popular due to its simplicity and accuracy. Some assumptions and estimates have to be made, but they can be adjusted fairly easily without sacrificing too much time or resources. It's clear why the DCF model is the industry standard.