From what I can tell, practically all stocks’ oil and gas reserves will have a Net Present Value of roughly 2-7 times the trailing twelve months’ cash flow. One relevant article is titled: “The Valuation of Oil and Gas Properties: Are They Really Worth 3x Cash Flow?“. For conventional wells, the 3X rule of thumb should come fairly close to the NPV in most cases.
I use this shortcut to get a quick sense of whether or not an E&P is massively overvalued. Currently I only short E&Ps and am not seeing any undervalued E&Ps even though these stocks have fallen a lot.
Here is a Google Sheet that you can copy and play around with:
Extracting trailing cash flow
If you’re lazy, you can use trailing EBITDA.
If you don’t mind a little more work, you can go to the statement of cash flows and look at (A) cash flow from operations – (B) changes in working capital. Pay attention to acquisitions as they may distort trailing cash flow figures. It’s up to you whether you want to make adjustments for:
- Egregiously excessive corporate overhead. I wouldn’t adjust for this and would leave excessive corporate overhead baked in. This penalizes the company for poor corporate governance. Such companies deserve to trade at a discount to their net asset value.
- Stock-based compensation. Because I’m looking to short E&Ps, it is ok for me to pretend that stock-based compensation is not an expense. (It is an expense but it is ok to conservatively overstate the NPV of a company’s assets.)
Because commodity prices have been volatile, you can adjust cash flow further to account for current prices or the current strip pricing.
The effect of hedging should be removed, although it can be tedious to figure out the cash impact of hedging.
Commodity prices – Difficult to predict but obviously a key variable. You can make the model more complicated to account for forward strip pricing, which will make a small/medium difference.
The price of land, land rights, and leases – Land rights generally do not generate any cash flow. So, my shortcut method will completely ignore the value of land. You should definitely add the value of land when valuing a company’s assets. Fortunately, land is currently easier to value because oil prices have fallen so much. Because land is leveraged to commodity prices, you could assume that it is worth a fraction of its acquisition cost. Or, you can assume that the land is not worth more than book value.
Conventional or unconventional? – The 3X rule of thumb works fairly well for conventional wells. For a vertically drilled shale well, the NPV will likely come closer to the 7X cash flow range. Those types of wells tend to have low decline rates. For a horizontally drilled shale well with modern fracturing techniques, the answer is tricky. Decline rates can be 30-70%+ initially. After several years, decline rates may drop significantly… maybe in the range of 5-15%. Young wells will come closer to the bottom end of the 2-7X range while mature wells could come closer to the higher end of the 2-7x range. For most publicly traded companies, there will be a mix of new and somewhat old horizontal shale wells. The NPV will likely be somewhere in the middle.
Decline rate – This assumption makes a big difference. Unfortunately, public E&Ps don’t disclose a honest estimates or much technical data. So, this is often a question mark. If you play around with the entire 5-20% range for decline rates, you can see that the NPV will largely be within the 2-7X cash flow range.
Fixed and variable operating costs – These make a difference but not a huge difference. Operating costs could rise over time if there is water in the well. Declining pressure could create additional costs for compression and/or artificial lift. (I did not try to model costs related to water or declining pressure.)
Midstream contracts and minimum volume commitments – These are hidden liabilities in a low commodity price environment.
Midstream assets – Some E&Ps do have midstream assets that can potentially be worth well over 7X cash flow. Fortunately, most E&Ps do not have enough midstream assets to ‘move the needle’ in terms of valuing NPV.
Well abandonment costs – I did not model this. You can get this data from reading the 10-K. In practice, some companies could delay abandonment as much as possible. This may keep the NPV of this liability very low.
Discount rate – I use 8%. Many E&Ps took on some pricey debt so a high discount rate is usually appropriate. Of course, nobody really knows what the exact discount rate should be.
What I think of oil and gas E&Ps
Um… almost all of them will go bankrupt at current oil prices. This happens even if you assume 7x cash flow. Overvaluation continues to be easy to find.
There’s a chance that some of them may not actually go to zero if they manage to sell equity and are lucky enough to have debt with long maturities. There could be some zombie companies that end up frustrating the shorts if commodity prices happen to rebound.
Wall Street has done a really, really bad job at analyzing these companies so opportunities exist on the short side. I’m greatly amused that some analysts value E&Ps based on an EBITDA multiple.
Promising DCA techniques emerge as widespread public debate focuses on shale gas forecasts – In particular, I pay attention to what professor John Lee has to say.
My approach to shorting oil and gas – An old 2014 post where I outlined my approach back then. At the time, I did not know how to guestimate NPV. I had the right idea about GPOR (not the best short) and MILL (currently in bankruptcy and the CEO is facing fraud accusations).