"Tell me where I'm going to die, that is, so I don't go there."
~ Charlie Munger
This is a "DO NOT" article.
What are some of the common mistakes investors make when analyzing E&P companies?
Mistake 1: DO NOT focus on production growth!
Focusing on production growth is one of the biggest mistakes an investor can make. Why? A majority of the E&P companies out there grow UNPROFITABLY.
As I mentioned in my last article, there are several key variables an investor has to understand before investing in E&P.
- What's the cost to simply replenish the production that will be lost this year due to natural decline?
- What does FREE CASH FLOW look like if the company simply maintains production?
- What's the return on capital?
If you sift through E&P company slides, a lot of them will point out how fast they've grown productions, but that's not the right way to think about it. It boils down to how much profit will you make. All the production wouldn't do you any good if you don't make money! If you look at Ultra Petroleum (NASDAQ:UPL) and SandRidge (NYSE:SD), they are classic examples of growth at any cost. Even if these two companies kept production FLAT, they would be free cash flow-negative. That's a bad investment.
Mistake 2: PV-10 is NOT REALISTIC.
PV-10 usually uses some arbitrary commodity price assumptions. It could be a lot higher than what STRIP is implying or lower, but nonetheless, it extrapolates a lot of assumptions forward as if certain costs are static. That's unrealistic in the E&P business, as most of the firms need to spend additional capex on infrastructure. Due to this spending, capital efficiency numbers will increase, making the company less profitable on a whole.
Another way to think about this is to imagine buying a condo, but in order to rent it out at the fair market price, you have to renovate the condo with new appliances. This would eat into your total cost and reduce the actual return implied. Taking a PV-10 is similar to assuming you can buy a condo for x price and rent it out at x price. It might not be that simple.
How is PV-10 calculated?
Most E&P firms will disclose their PV-10 value annually. One of the appraising firms will appraise the value of the company's assets using a conservative/realistic price deck and calculate what the total value of the company's assets are worth, discounted back to present value using a 10% discount rate.
This could be thought of as a reserve test, where the appraiser would benchmark the company's cost structure to its ability to extract oil and gas out of the ground profitably. If it were not profitable to extract, then it would not be counted as reserve. On a side note, this is also how banks determine what a company's credit line will be.
The problem with using PV-10 for value is that the assumptions used in the model might not pan out. It also does not incorporate what happens between now and 10 years from now. Prices could spike causing a temporarily inflated PV-10 value, or they could plummet and cause PV-10 values to be negative. All in all, this just isn't a sound way to calculate what a company is worth.
Mistake 3: Don't listen to the sell side when it comes to E&P investing!!!
The sell side is notoriously used by E&P companies to inflate share prices by using stupid forecasts so the company can raise additional equity.
What you will notice when you look through Wall Street sell-side ratings on E&P is that most of them have horrendous track records in getting the call right. Most are influenced by near-term moves in commodity prices and share price performances. Their recommendations will almost always lag the share price performance.
What is the right way to look at E&P companies?
Follow these steps:
- Check acreage/play. Where does the company drill?
- What's the cash cost to drill?
- What's the cost to replace production (capital efficiency)?
- What's management like? Are they growing organically? Are they growing through acquisitions? Are they promotional?
- What's the company valued at on a per flowing basis? Is this properly valued relative to the asset's decline rate plus corporate netback?
It will require some time to answer these first five questions, as you most likely will have to reach out to management and competitors to get a good gauge of the company's assets and operational style.
If you can avoid the most common pitfalls, you will be a better E&P investor than 99% of the E&P investors out there. As Don Gray told me, "People are stupid to focus on growth. Growth is nothing without profits to back it! Idiots!"
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.