When valuing a business, it is critical to understand the subject company’s position in the market, its operations, and its financial condition. A thorough understanding of the oil and gas industry and the role of refineries is important in establishing a credible value for a business operating in the oil and gas refining space.
Oil and Gas Supply Chain
The oil and gas industry is divided into three main sectors:
- Upstream (Exploration and Production)
- Midstream (Pipelines)
- Downstream (Refineries)
Exploration and production (E&P) companies search for reserves of hydrocarbons where they can drill wells in order to retrieve crude oil, natural gas, and natural gas liquids. E&P companies then sell the commodities to midstream companies who use gathering pipelines to transport the oil and gas to refineries. Refiners convert raw crude and natural gas into products of value, such as transportation fuels.
Oil and Gas Refinery Operations
Crude oil itself has little end use. Refiners create value by converting crude oil into various usable products. Transportation fuels, such as gasoline, diesel, and jet fuel, are some of the most commonly produced refined products. Other refined products include heating and lighting fluid, such as kerosene, lubricating oil and waxes, and asphalt. Refineries are capital intensive and their configuration depends largely on their physical location, available crude oils, product requirements, and environmental standards.
Valuing an oil and gas refinery requires the consideration of a wide range of issues (far too many to list in full here), with primary considerations as outlined below.
- The price of inputs. The price of crude oil fluctuates due to changes in world demand and supply. Many refiners hold large volumes of crude inventory, but as the price of crude oil fluctuates, refiners face risk associated with the falling value of their inventory. Thus, in order to reduce risk refiners should shorten their timeline from purchasing crude oil to selling the finished product and/or use derivatives to hedge the risk associated with volatile oil prices.
- The price of refined products. There are four main components to refined product prices: (1) Crude Oil Prices, (2) Wholesale Margins, (3) Retail Distribution Costs, and (4) Taxes. Generally, input prices and wholesale margins drive fluctuations in product prices as the last two are relatively stable. However, President Trump has indicated that he hopes to lower corporate taxes.
- Crack spread. A refiner’s margins are generally determined by the crack spread, which measures the prices of refined products compared to the cost of crude oil. The price of transportation fuels generally moves in sync with the prices of crude oil, but the price of some refined products such as asphalt and lubricating oils is not as closely correlated with crude oil price changes.
- Environmental regulation. The refining industry has historically been heavily regulated. Regulations such as the RTR & NSPS aim to control air pollution from refineries and provide the public with information about refineries’ air pollution. President Trump is working to establish a more energy friendly environment and has signaled his intention to sign the repeal of many methane emission regulations if the repeal is passed through both Houses of Congress.
- Heavy vs. light crude. Most U.S. refineries were built to process heavy crude. However, the onset of U.S. shale drilling has led to a surplus of light sweet crude that U.S. refineries were not originally built to process. While the refining process of heavy and light crude is generally the same, the refining of light crude is less costly.
Oil and Gas Refinery Financial Analysis
When valuing a business, it is critical to understand the subject company’s financial condition. A financial analyst has certain diagnostic markers that tell much about the condition of a business.
- Balance Sheet. The balance sheet of a refinery is dominated by inventory and fixed assets. According to RMA’s annual statement studies, 16.3% and 32.2% of petroleum refineries’ assets are inventory and fixed assets, respectively.1 Because refining is a capital intensive business, it is important to consider the current operating capacity of a company’s fixed assets in order to determine if future growth will require significant capital expenditures. If a refinery hopes to expand refinery throughput beyond the current refining capacity, it will have to invest in more equipment.
- Income Statement. The development of ongoing earning power is one of the most critical steps in the valuation process, especially for businesses operating in a volatile industry environment. Cost of goods sold account for approximately 75% of sales according to the RMA data. Thus it is important to consider possible supplier concentrations when analyzing the income statement because disruptions in the supply chain can have significant income statement impacts to oil refineries.
How Does Valuation Work?
There are fundamentally three commonly accepted approaches to value: asset-based, market, and income. Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration.
The Asset-Based Approach
The asset-based approach can be applied in different ways, but in general, it represents the market value of a company’s assets minus the market value of its liabilities. Investors make investments based on perceived required rates of return, and only look at assets as a source of rate of return. Oil and gas refineries are asset intensive businesses. They have distillers, crackers, cokers, and more. While an asset value consideration can be a meaningful component of the overall valuation of an oil and gas refinery, it is essentially the income generated by these assets that typically drives the value of a business. For this reason, the asset-based approach is typically not the sole (or even primary) indicator of value.
The Market Approach
The market approach utilizes market data from comparable public companies or transactions of similar companies in developing an indication of value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.
In the downstream oil and gas sector, there are ample comparable public companies that can be relied on to provide meaningful market-based indications of value. Such options are Alon US Energy Inc., CVR Refining, LP, Valero Refining, and Western Refining. Acquisition data from industry acquisitions (typically a median from a group of transactions) can be utilized to calculate a valuation multiple on the subject company’s performance measure(s). This will often provide a meaningful indication of value as it typically takes into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach. Additionally earnings multiples such as EV/ EBITDA can be used to calculate indication of values.
The market-based approach is not a perfect method by any means. For example, industry transaction data may not provide for a direct consideration of specific company characteristics. Say a company is a market leader and operates in a prime geographic market. Since the market and the specific company are relatively more attractive than the average transaction, the appropriate pricing multiple for this company is likely above any median taken from a group of industry transactions. Additionally, many companies in the oil and gas industry are vertically integrated and have significant midstream or marketing operations in addition to their refining operations. For example, Marathon Petroleum Company is a leading refiner in the US, but is also a marketer of refined products and has significant midstream operations. Clearly, the more comparable the companies and the transactions are, the more meaningful the indication of value will be. When comparable companies are available, the market approach can provide a helpful indication of value and should be used in determining the value of a refinery.
The Income Approach
The income approach can be applied in several different ways. Generally, such an approach is applied through the development of an ongoing earnings or cash flow figure and the application of a multiple to those earnings based on market returns. An estimate of ongoing earnings can be capitalized in order to calculate the net present value of an enterprise. When determining ongoing earnings historical earnings should be analyzed for non-recurring and non-normal income and expenses which will not affect future earnings. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market through the use of a capitalization rate.
Income is the main driver of value of a business; thus, the income approach should be considered when determining the value of your business.
Synthesis of Valuation Approaches
A proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules-of-thumb” (be they some multiple of revenue, earnings, or other) are dangerous to rely on in any meaningful transaction. Such “rules-of-thumb” fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.
An owner who is contemplating any kind of transaction or agreement based on value needs to know what their business is worth. Whether you are selling out or selling in, knowing the fair market value of your business will let you evaluate whether or not an offer for your company is reasonable. Additionally, many business owners fail to understand the valuation implications of buy-sell agreements. If you have other shareholders in your business who are non-family, and maybe some who are, you probably have some kind of buy-sell agreement between the shareholders that describes how the business (or business interests) will be valued in the event of a shareholder dispute, death, or departure from the business (even on friendly terms). A business owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the business.
Mercer Capital has long promoted the concept of managing your business as if it were being prepared to sell. In this fashion you promote the efficiencies, goals and disciplines that will maximize your value. Despite attempts to homogenize value through the use of simplistic rules of thumb, our experience is that each valuation is truly unique given the purpose for the valuation and the circumstances of the business.
Mercer Capital has experience valuing businesses in the oil and gas industry. We hope this information, which admittedly only scratches the surface, helps you better shop for business valuation services and understand valuation mechanics. We encourage you to extend your business planning dialogue to include valuation, because sooner or later, a valuation is going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal and business life.
For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us at 901.685.2120.
1 2016-2017 RMA Statement Studies. NAICS #324110. Companies with greater than $25 million in sales.