Calculating Breakeven Prices And A Valuation Metric For Oil And Gas Companies

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Includes: CHK, GPOR, PQ, RICE, SWN, UPL, WLL
by: Michael Bissell, CFA

Summary

What does it mean for an oil and gas company to “breakeven”?

As oil and gas companies produce multiple products, how do you calculate breakeven prices?

Using the same methodology for calculating breakeven prices, a valuation metric can be developed that is useful for comparison between companies.

Introduction

I decided to write this article after reading the MarketWatch column "11 Oil Stocks That Are Forecast to Rise Up to 53%" by investing columnist Philip van Doorn. In this column, van Doorn presented breakeven prices from Stern Agee CRT for a so-called "gassy" group of companies: Ultra Petroleum (NASDAQ:UPL), Gulfport Energy (NASDAQ:GPOR), Rice Energy (NYSE:RICE), Southwestern Energy (NYSE:SWN), Chesapeake Energy (NYSE:CHK), and PetroQuest Energy (NYSE:PQ).

Company

Ticker

Estimated breakeven price for gas - 2015

Estimated breakeven price for gas - 2016

Estimated oil production %

Estimated NGL production %

Estimated gas production %

Ultra Petroleum Corp.

UPL

$2.82

$2.76

7%

0%

93%

Gulfport Energy Corp.

GPOR

$2.99

$2.85

10%

15%

75%

Rice Energy Inc.

RICE

$3.22

$3.04

0%

1%

99%

Southwestern Energy Co.

SWN

$3.49

$3.36

1%

5%

93%

Chesapeake Energy Corp.

CHK

$4.75

$5.11

17%

10%

73%

PetroQuest Energy Inc.

PQ

$4.78

$4.94

8%

15%

76%

Being an investor in CHK, I was concerned that this presentation gave the false impression that CHK could only "breakeven" if natural gas prices rose to $4.75/MCF, ignoring the likelihood that prices for oil and NGL would rise along with prices for natural gas, and the favorable impact this would have on CHK's profitability. Analysts and the press that cover oil and gas exploration and production companies frequently cite breakeven prices for oil and natural gas without defining "breakeven" prices or how they are calculated. Typically, the breakeven price is given for oil in terms of West Texas Intermediate (WTI) pricing or natural gas in terms of Henry Hub. In reality, I know of no pure plays in the industry that produce only dry gas or "black" oil, but rather a mix of oil, natural gas, and natural gas liquids (NGLS). Therefore, when deriving the breakeven gas prices in the above table, did the analyst assume current NGL and oil prices? Did the analyst convert oil and NGL production to their natural gas equivalent using the SEC mandated 6 MCF/BBL conversion factor?

Breakeven Prices - A Definition

Although there are probably various definitions of "breakeven" prices used by analysts, I define them as the prices for oil, NGLs and natural gas that will generate earnings before interest, taxes, depreciation/depletion, amortization and exploration (EBITDAX) equal to maintenance capital expenditures plus interest. The interest is cash interest paid, which includes capitalized interest, but ignores the tax shielding benefits of interest expense.

I define maintenance capital expenditures as those well development costs (drilling and completion) required to replace produced proved developed (PD) reserves with proved undeveloped (PUD) reserves. I ignore costs for land or lease acquisition and for exploration. Thus, when comparing valuations based on breakeven prices, I attribute more value to companies such as CHK and SWN with large acreage holdings, both proved and unproved.

Calculating Breakeven Prices

Calculations for determining breakeven prices will be demonstrated using spreadsheet excerpts for the Stern Agee "gassy" companies from the above chart, with the addition of Whiting Petroleum (NYSE:WLL), which I added as it was Stern Agee's top recommendation. All currency values are in millions of US dollars, except prices. These calculations are presented for a single WTI and Henry Hub assumed pricing case:

Quarterly production of oil, NGL and natural gas from the latest 10-Q are assumed as the run rate for calculating estimated 2015 annual production by multiplying by a factor of four. Premiums or discounts to WTI and Henry Hub prices for oil, NGL and natural gas are determined by comparing unhedged prices received, as reported in the 10-Q, with the quarterly averages for WTI and Henry Hub. These premiums or discounts are then added or subtracted to or from the assumed 2015 average WTI and Henry Hub prices to obtain average prices that would be received, which are then multiplied by the annual production to get estimated annual sales revenue at these assumed prices.

Expenses for transportation (including gathering and processing), production taxes, lease operation and general and administrative (G&A) are also annualized by multiplying the 10-Q values by four and then subtracted from sales revenue to obtain unhedged EBITDAX. A hedged EBITDAX can also be estimated by adding the market value of hedges in place as of the end of quarter (this value is also available from the 10-Q).

The estimated annual maintenance capital expenditure is derived from the latest 10-K section on "Supplementary Information." There you can find a table summarizing the future net cash flows relating to proved oil, natural gas, and NGL reserves based on the standardized measure for the previous three years. Take the future development costs from this table and divide by the proved undeveloped reserves, expressed as barrels of oil equivalent (BOE), for the end of period of the most recent year. The proved undeveloped reserves are also found in the "Supplementary Information" section in the table summarizing changes in estimated reserves for the previous three years. The resulting estimated maintenance capex ($/BOE) is then multiplied by the annual production (expressed as BOE) to give the estimated maintenance capital expenditure.

Finally, using Excel's Goal Seek function, breakeven gas prices for each company can be determined by requiring EBITDAX - maintenance capital expenditure - interest expense to be equal to zero. The following are the results for various assumed WTI prices:

Comparisons between the prices I have calculated and Stern Agee's are not possible without knowing Stern Agee's assumptions and methodology.

A Valuation Metric - "Free Cash Flow" Yield

Although breakeven prices are useful in gauging to what level natural gas prices must rise for a company to make a profit given fixed oil prices, they do not tell you anything as to a company's investment value, as breakeven prices do not depend on stock prices. However, it is a simple matter to divide a company's "free cash flow," defined as EBITDAX - maintenance capital expenditure - interest expense, by its market capitalization. We have done this for the companies examined above using both EBITDAX with and without hedges using closing stock prices as of June 26, 2015.

Investment decisions should not be based on just the above metrics, or for that matter, any single metric. What these metrics do illustrate is the large extent to which oil and gas companies' profitability depends on product pricing.

Disclosure: I am/we are long "CHK" AND "WLL".

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.