05-01-09 how to value e and p companies

8/2/2019 05-01-09 How to Value E and P Companies

http://slidepdf.com/reader/full/05-01-09-how-to-value-e-and-p-companies 1/6

Friday, May 1st, 2009

James Sterling 1

Gain On ‘07 Recommendations: 44.16%

Gain On ‘08 Recommendations: 45.39% Gain/Loss to Date On ‘09 Recommendations: 19.09% (Based on $20 million portfolio*)

‘09 Indices Gains/Losses to Date:

Dow Jones: -9.10%, NASDAQ: 5.33%, S&P 500: -5.83% OIH: 17.19%, XLE: -5.76%

Avg. of OIH & XLE**: 5.71% SterlingAccount: 19.09%***

*Except when the Fund is fully invested, the SterlingAccount assumes that interest from the moneymarket offsets commissions.

Percent of Fund in Money Market or Cash Equivalents: 10% Percent of Fund Invested: 90%

***The OIH is composed mostly of large hydrocarbon service companies, contract drillers andseveral major oil companies. The XLE is composed mostly of large hydrocarbon exploration and

production independents and major oil companies.

***Total gains or losses are included from positions originated and closed out in’09, whichcontributed a net gain of $3,817,065.22. For detail see track record published at the end of each

month. The latest issued ‘09 track record can be seen here. Click at top on the ‘07 and ‘08 gains tosee detailed yearly track records.

How to Value E&P Companies

As any investor has learned in recent market times, landing the big catch among publiclytraded E&P stocks is a function not only of patience, but of applying the right financialcriteria when analyzing the annual reports or 10-Ks of upstream independents.

Just what are these criteria? E&P analysts use several yardsticks to determine if acompany’s shares are worth buying. In the main, they pay attention most to these factors:

http://www.globalenergyanalysts.com/SterlingAccount/2008/01-12-08_Alert_Throwing_In_The_Sponge_And_2007_Track_Record_Performance_With_Appendix.pdf



http://www.globalenergyanalysts.com/SterlingAccount/2009/01-02-09_Track_Record_To_Date.pdf












James Sterling 2

• A producer’s present and potential cash flow per share;• Total capitalization or total enterprise value/EBITDA (earnings before interest,

taxes, depreciation and amortization);• Full-cycle return on investment; and•

Share price versus a company’s breakup value or appraised net worth.

The managements of E&P companies aren’t being judged by the market on their abilityto generate net income, but rather on their ability to take the cash they generate fromproduction and invest it in existing or new properties to improve the underlying assetvalue of their companies.

Annual earnings numbers is an unreliable tool for comparing upstream companiesbecause some operators use successful-efforts accounting whereby they expense—orsubtract from earnings—exploration costs in the same year they occur; those using full-cost accounting, on the other hand, fully capitalize and then amortize their exploration

costs over future years.

With cash-flow analysis, add back in the exploration expenses for successful-effortscompanies, thereby creating more of a level playing field—one that allows for similarcomparisons.”

But there’s a more compelling reason to place a premium on cash flow. That’s what anoperator must use (to fund drilling or acquisitions) to replace the reserves he produces ina given year. As such, it serves as a gauge of his ability to grow his asset base.”

The future success of upstream companies depends on their ability to ward off production

declines by cost effectively finding new reserves with cash flow generated from currentsales. Those that that can grow their cash flow by growing their production profiles arethe ones that are going to improve their bottom line and the ones in which you want toinvest.

E&P analysts, however, don’t regard cash flow analysis as the stand-alone tool formeasuring an upstream operator’s investment worthiness. On the contrary, they believean investor should also place a premium on a company’s share price versus its net assetvalue (NAV).

Every now and then, you come across a situation where an independent has hit a homerun or is about to tremendously increase the underlying value of its reserve base—but themarket hasn’t recognized this yet in the company’s share price.

When valuing E&P companies, an analyst may focus on total enterprise value (stock market equity plus debt and preferred shares)/EBITDAX (earnings before interest, taxes,depreciation, amortization and exploration expenses).




James Sterling 3

It’s a debt-adjusted ratio that takes into account a company’s unlevered cash flow. That’sa useful equalizer in comparative valuation analysis in that it eliminates the effect of varying high- to-low-debt capital structures on cash flow.

This valuation yardstick, also known as total capitalization/EBITDA, can be an eye-

opener for investors. Here’s a hypothetical example: Alpha Oil Co. and Beta Oil Co. bothhave EBITDA of $10 million. But while Alpha has $100 million of equity and no debt,giving it a total capitalization of $100 million, Beta has $100 million of equity and $100million of debt, giving it a total capitalization of $200 million. Thus, the totalcap/EBITDA multiple for Alpha is only 10 while the same multiple for Beta is 20.

Having compared both companies on the same debt-adjusted cash flow basis, and havingrecognized the financial leverage of both and their ability to fund drilling programs,you’d rather invest in the hypothetical Alpha company with the total cap/EBITDAmultiple of 10.

Among other investments used are NAV to identify stocks that are trading below theirinherent asset or liquidation value. Similarly, scrutinizing stock price/discretionary cashflow helps identify stocks that are comparatively undervalued, this time on an after-interest, after-tax, cash-flow multiple basis.

In addition, look at cash flow per unit of production/finding costs. The reason? This ratiois a good proxy for return on investment and implied growth rates.

However, an investor should be wary of operators with declining or flat production, highfinding costs versus cash flow generated per unit of production, lack of high-growth-potential areas, and too much debt.

Emphasizing yet another valuation metric, place a high premium on full-cycle return oninvestment (cash flow per barrel equivalent divided by multi-year average finding costs).

Cash flow growth means nothing unless a producer is making money on that incrementaldollar that it invests. Calculating a full-cycle return on investment directs investorstoward those companies that are making efficient capital investments and away fromthose that are making inefficient investments.

Put another way, it helps investors avoid paying five times cash flow for upstream stockswith poor returns versus paying five times cash flow for those with tremendous returns.

When it comes to cash flow or NAV analysis, investors should pay particular attention tounderlying pricing assumptions for oil and gas, given the volatility of these commodities.

The way to deal with the problem of volatility in our analysis is to use price-normalizedcash flow and asset values, that is, use historical five-year-average oil and gas priceassumptions in our valuations—not current spot prices. This can lead to a betterperception of investment opportunities.




James Sterling 4

Another caveat the analyst advances: when investors today scrutinize a producer’sdiscretionary cash flow, they should pay more attention to how much maintenance capitalspending is needed just to keep that company’s asset base flat—and how much free cashflow is actually left over to grow that producer’s reserve base.

If two operators each have $100 of discretionary cash flow, and one of them has to use allof it just to replace what has already been produced, then that company is just standing inplace. If the other, meanwhile, has finding and development costs only half as much asthe former producer, it’s clear that’s the one that’s going to have the free cash flow togrow.

If an investor can buy a producer’s reserves in the stock market for less than what anindependent engineering report says they’re worth, then there’s an opportunity to makemoney as those reserves are produced and sold in future years.

If the net present value of a producer’s future oil and gas cash stream—plus the value of its other assets less debt—is $1 per share, and that company’s stock currently trades at 50cents per share, then you’ve discovered a stock that’s selling for half its breakup value.

Naturally, also focus on cashflow analysis—and with good reason. You might be lookingat the greatest bargain in the world as far as the discount-to-breakup value of a producer’sreserves in the ground, but if the company doesn’t have the money or wherewithal toproduce and sell those reserves at a profit, then those reserves can’t really be fullyexploited.

And neither can the investment.

Onsite Due Diligence

14 Important Things to Check On

1) Check local transportation. See if gas pipelines are nearby and determine the costof connection and the cost of compression necessary to equalize companywellhead pressure to pipeline pressure.

2) Talk to members of the drilling crew, including the tool pusher, to see if there areproblems associated with any of the company’s wells, such as sanding, casingdefects, and swelling of clay finds in perforated zones.

3) See if any environmental complaints have been filed concerning any of thecompany’s operations.




James Sterling 5

4) If necessary, do an independent check for pH levels at nearby rivers, streams andnearby bodies of water, since the company can be accused, fairly or unfairly, of environmental damage.

5) Use any one of a number of information sources to provide production history of

nearby wells or analog fields.

6) Production history and test results of each analog or offset well are analyzed.

7) In-house or third party engineers and geological staff project future production,revenues, operating cost and net cash flow from proposed wells.

8) A preliminary physical inspection is performed – including testing andenvironmental assessment of existing wells, well sites and equipment.

9) Potential gas purchasers are contacted for likely wellhead prices, transportation,

availability and costs and potential for future price changes.

10) Local and national engineering firms independently review estimated reserves andprojected net income.

11) In-house cost accountants review financial and accounting data for accuracy andconsistency.

12) Investigations are conducted of key personnel who may be retained.

13) Title checks and property searches are conducted to ensure that all leans,mortgages and UCC filings are known.

14) A final physical inspection is conducted, including tests of existing wells that arepart of the deal.




James Sterling

Sterling Account (“Sterling”) is not registered as a securities broker-dealer or investment adviser with the U.S. Securities andExchange Commission or any state securities regulatory authority. Specifically, Sterling relies upon an exemption from theregistration requirements under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) provided for in Section202(a)(11)(D). This exemption is available for the publisher of any “bona fide financial publication of general and regularcirculation.” Sterling is not responsible for trades executed by subscribers to the services based on the information included inthe website and any other publications from Sterling (collectively, the “Publications”). The Publications and the informationcontained therein do not represent individual investment advice or a recommendation to buy or sell securities or any financialinstrument nor are they intended as an endorsement of any security or other investment. Furthermore, the Publications do notconstitute an offer or solicitation to buy or sell any securities or individualized investment advice. Any information contained inthe Publications represents Sterling’s opinions, and should not be construed as personalized investment advice. Sterling cannotassess, verify or guarantee the suitability of any particular investment to any particular situation and the reader of thePublications bears complete responsibility for its own investment research and should seek the advice of a qualified investmentprofessional that provides individualized advice prior to making any investment decisions. All opinions expressed andinformation and data provided therein are subject to change without notice. Sterling, its officers, directors, employees and/oraffiliates, may have positions in, and may, from time-to-time make purchases or sales of the securities discussed or mentioned inthe Publications.

6

05-01-09 how to value e and p companies

Documents