Important Industry Factors
A review of the oil and gas industry is important in establishing a credible value for any business operating in this space. Such a review should consider a wide range of issues (far too many to list in full here), with primary considerations as outlined below.
- Price Volatility. The oil and gas industry is characterized by high price volatility. The size and global nature of the oil and gas market means that these prices are influenced by countless economic – and sometimes political – factors affecting individual producers, consumers, and other entities that comprise the global market.
- Technology. Technology in the oil and gas industry changes rapidly and has the potential to materially impact the market. Adoption of innovative drilling techniques, such as horizontal drilling and hydraulic fracturing, has made oil and gas production quicker, easier, and relatively cheaper.
- Regulation. The oil and gas industry is heavily regulated by various entities, and regulations on operations can have a costly impact on the industry. The regulatory environment is constantly changing and regulations vary across regions and countries.
- Variation by Oil and Gas Play. Drilling economics vary by region. There are geological differences between oilfields and reserves that make it harder (thus more costly) to drill in some places than others. Accordingly, the value of any E&P company is strongly influenced by its location, and it is important to consider geological differences when valuing E&P companies.
Financial Considerations
When valuing a business, it is critical to understand the subject company’s financial condition. E&P companies rely on their oil and gas reserves to produce revenue. Understanding the drilling economics is crucial in understanding a company’s value.
A break-even analysis is a helpful tool used to analyze drilling economics. A break-even analysis can be used to compare how much it costs to produce one barrel of oil versus the revenue generated per barrel. This can reveal whether a company is losing money through the production process and determine at what price a company can be profitable.
An analysis of a company’s working capital, leverage, and interest coverage ratio can help paint a better picture of a company’s financial position.
To properly consider a company’s current financial position, it is important to understand management’s plan for future development of wells. Since oil is a depleting asset, in order to continue at current levels of production, oil companies must continuously explore for reserves and develop new wells. Thus, when valuing an E&P company in today’s market, it is important to consider the company’s ability to meet its capital needs. An analysis of a company’s working capital, leverage, and interest coverage ratio can help paint a better picture of a company’s financial position.
E&P companies have extremely high operating costs, in large part due to the magnitude of exploration expenses. Exploration endeavors, although not always successful, are extremely costly. For this reason, many in the oil and gas industry prefer to look at EBITDAX multiples rather than EBITDA multiples. EBITDAX represents EBITDA before exploration expenses and tends to be a better metric to compare E&P companies because it negates the effect of a company’s selected accounting policy.
What Does the Valuation Process Entail?
There are three commonly accepted approaches to value: asset-based, market, and income. In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value.
Mineral reserves are an E&P company’s main generator of value, but because they are depleting assets and are often owned through working interests, their value can be tricky to understand. Reserves are typically divided into two groups: proved and unproved reserves. Proved reserves are further classified as proved developed producing reserves (PDP), proved developed non-producing reserves (PDNP), and proved undeveloped reserves (PUDs); unproved reserves are further classified as probable and possible. The valuation methodology used depends on the type of reserve. Generally, the income approach is the most supportable approach for valuing proved reserves and the market approach is generally used to value PUDs and unproved reserves.
The Income Approach
The income approach can be applied in several different ways. For companies operating in the oil and gas industry a discounted cash flow analysis is most common because reserves produce unequal annual cash flows that can be projected by a petroleum engineer in a reserve report. This approach allows for the consideration of characteristics specific to the subject company and their reserves.
These future production estimates from reserve reports can be used to project revenue throughout the remaining life of a well. Estimates of future cash flow can be discounted back to the present using an appropriate discount rate (rather than the 10% industry standard used to calculate PV-10).
While the income approach is typically a reliable estimate of value for proved reserves, it is not always helpful in determining the value of PUDs and unproved reserves because the production of unproved reserves is ambiguous. Rather, we generally use the market approach.
The Market Approach
The market approach utilizes pricing multiples from guideline transaction data or valuation multiples from a group of publicly traded companies to develop an indication of a subject company’s 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 many ways, the market approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.
While geography may not factor into the selection of guideline public companies in many industries, the location of an E&P company is one of the most important factors to consider when selecting similar companies in the oil and gas industry. Drilling economics vary across play; thus, it would be inaccurate to select a company operating in the Permian Basin as a comparable company to one operating in the Bakken Shale in North Dakota.
Acquisition data from industry acquisitions can be utilized as a multiple on the subject company’s performance measure(s). For unproved reserves in particular, because production is uncertain, the market approach provides the most meaningful indication of value. Using an EV/acreage multiple derived from transactions of similar companies, analysts can gauge the value of a company’s unproved reserves.
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” 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.
Mercer Capital has long promoted the concept of managing your business as if it were going to market. 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 encourage you to extend your business planning dialogue to include valuation. For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us.
