How to Use an EV/Production Multiple
Oil and gas analysts use many different metrics to explain and compare the value of an oil and gas company, specifically an exploration and production (E&P) company. The most popular metrics (at least according to our eyeballs) include (1) EV/Production; (2) EV/Reserves; (3) EV/Acreage; and (4) EV/EBITDA(X). Enterprise Value (EV) may also be termed Market Value of Invested Capital (MVIC) and is calculated by the market capitalization of a public company plus debt on the balance sheet less cash on the balance sheet. In this post, we will dive into one of these four metrics, the EV/Production metric, and explore the most popular uses of it.
EV/Production is a commonly used valuation multiple in the oil and gas industry which measures the value of a company as a function of the total number of barrels of oil equivalent, or mcf equivalent, produced per day. When using this multiple, it is important to remember that it does not explicitly account for future production or undeveloped fields.
While the above definition was provided by Investopedia, the source goes on to explain the meaning of the multiple in the following way:
All oil and gas companies report production in BOE. If the multiple is high compared to the firm’s peers, it is trading at a premium, and if the multiple is low amongst its peers it is trading at a discount. However, as good as this metric is, it does not take into account the potential production from undeveloped fields. Investors should also determine the cost of developing new fields to get a better idea of an oil company’s financial health.
While some of the above explanation may appear true; the detail, analysis, and reason is lacking. Let’s more fully investigate the above notes:
- BOE or MCFE. Not all oil and gas companies report in barrel of oil equivalent per day (BOEPD). Those that are primarily dry gas producers will choose to report in MCF equivalent per day (MCFEPD). On the other hand, majority oil producers will report in BOEPD. One take away analysis to consider is that many times the metric a company uses to report production communicates the core production activity of the company (i.e. a company that reports in BOE wants to communicate they primarily target oil, while a company that reports in MCFE wants to communicate they primarily target gas).
- Premium or Discount. If the multiple is higher compared to its peers, it only appears to trade at a premium, but it does not mean the market value of the company is at a premium or more expensive than its peers. If it trades at a discount to its peers, the same is also true; it does not automatically mean the MVIC of a company is cheaper than its peers. To draw that conclusion, one assumes each of its peers has the exact same future production outlook, the exact same well locations and the exact same management team, just to name a few. Making this assumption in isolation is in error. Instead, analysis should be performed to understand the why behind a perceived “premium” or “discount.”
- Current or Future Production. The metric uses current production as an indication of value for the company. When using this metric, it could be assumed that (1) the current oil/gas/natural gas liquids mix will stay the same; (2) the current production level will continue on its previously experienced decline rate; and (3) the equivalency formula to translate gas production into oil production (typically 6.1 mcf = 1 barrel of oil equivalent) will not change. This metric fails to account for visibility into future production. When analyzing an E&P company, future production should always be considered.
While this multiple is useful, it also has its shortfalls. As with all multiples, it should never be used as the sole indicator of value. As an example, using this multiple in isolation would give zero value for an E&P flush with acreage and no production.
We had a client with investments in an oil and gas company that was facing a transfer of ownership decision. During negotiations certain parties involved were convinced the only way to value, and therefore the only way they would pay for, an E&P was to utilize an EV/Production multiple and nothing else. They backed their position with their transaction experience of buying oil and gas assets as well as their knowledge of industry participants. We believed utilizing that particular method significantly undervalued our client. While the company had very little production, the acreage rights were significant as well as the PV 10 reserve report. We assisted our client through the transaction process by utilizing multiple valuation approaches, not solely the one a potential suitor strongly suggested.
Multiples such as EV/Production can provide context for market pricing in the form of a range. We would never recommend using one market multiple as the only value indication for a subject company, particularly a non-publicly traded company. Ideally, market multiples should be used as one of many value indicators during analysis. While there may be facts and circumstances that prohibit the use of multiple value indicators, it is always advisable to (1) understand the implications of using a specific multiple; (2) understand its weaknesses; and (3) use other value indications together. When observing the EV/Production multiple, reconcile the observations with other valuation multiples and valuation indications for a reasonable analysis. For assistance in the process or other valuation analysis for an energy company, contact a member of our oil and gas team to discuss your needs in confidence.