There are two main approaches:
- Look at management’s integrity.
- Look at the technical data and/or perform proper due diligence.
If management has questionable integrity, then it’s probably best to stay away from the stock. Shady people usually end up finding ways to steal from shareholders. They may also have misled investors into overvaluing the stock (e.g. inflated reserves, misleading investor presentations, paid stock promotion, etc.). It’s not worth it.
Proper due diligence
- Access to technical data.
- Skilled engineers who can understand the data.
I don’t know why institutional investors bother investing in stocks where they aren’t performing due diligence and are at a huge disadvantage to other parties. When oil and gas companies take each other over, the company shopping itself may open a data room so that others can perform proper due diligence.
As well, I don’t like situations where insiders have a huge information advantage over investors. Very few management teams in the independent oil and gas industry try to put themselves on a level playing field with their shareholders.
Due diligence shortcuts
The ratio between undiscounted and discounted PV-10 values
One way to inflate reserve estimates is to assume unreasonably long well lives. If this is happening, there will be lots of estimated revenue in the distant future. This revenue will have a very low present value compared to its undiscounted value. So, this will cause the ratio between undiscounted and discounted PV-1o values to be very high.
A ratio above 2:1 may or may not suggest that something is amiss.
Unfortunately, different oil/gas plays have different decline curves. Note that the shape of the decline curve affects the ratio between PV-10 values. The ratio is affected by both (A) how aggressive the reserve estimate is and (B) the nature of the oil/gas play. Ideally, I would want to look at the reasonableness of projected decline curves rather than a simple ratio between two PV-10 values. However, publicly-traded oil and gas stocks almost never release their projected decline curves. One way to reduce the impact of this distortion is to compare oil and gas stocks with similar types of wells. Hopefully, the real decline curves (whatever they are) and the lives of these wells are similar enough that the distortions aren’t too meaningful.
Proved developed non-producing reserves (PDNPs) or “behind pipe” reserves
Many PDNPs are legitimate. A well that isn’t yet connected to a gathering system will result in PDNP reserves. However, these PDNPs will only be a tiny meaningless fraction of the overall PV-10 value.
It is a red flag when “behind-pipe” reserves from shale wells contribute significantly to the overall estimated cash flows (e.g. if PDNPs are a fifth of all cash flows). Behind pipe reserves are reserves that require additional capex to recover. Because shale technology is so new, it is unclear what the economics of enhanced recovery techniques will be. It may be too soon to assume that these techniques are even economic at all for shale wells. The companies booking the most PDNPs are likely being much more aggressive in reserve estimation than their peers.
Companies that project that their shale wells will have lives of 30+, 40+, or 60 years are being more aggressive than their peers. Unfortunately, accounting rules do not force oil and gas companies to disclose this data even though it is often used in calculating depreciation.
B-factor and Dmin values
One common estimation method is to use modified Arps equations. (Not all reserve engineers choose to use them. Other methods can be used to estimate reserves.) The following PDF explains the underlying concepts:
A high “b-factor” and a low “dmin” (minimum decline) value will inflate reserves. These numbers are sometimes disclosed in investor presentations or in SEC correspondence letters (CORRESP filings on EDGAR).
Is management overly promotional?
Does management try to mislead investors with faulty metrics? (In my opinion, almost all independent oil and gas companies do this.) If management is trying to mislead investors in presentation, then it may also be likely the company’s reserve estimates are too aggressive.