The oil and gas sector is notoriously tricky to invest in given the technical nature of the field, the sometimes ambiguous terminology, the specialist line items present in accounting statements and the huge range of factors affecting profitability.
This multi-part series will provide a guide to valuation in the oil and gas industry and look at some common metrics used to value companies in this sector. In part one, we start with a general discussion of what makes these stocks different to others you may have analyzed and what factors affect their share prices. First, though, let’s lay down some basic terminology.
What does it mean?
Like most industries, the energy sector has some specialized terminology that we need to understand in order to really dig into more complex issues like valuation metrics. These include:
- The upstream sector has everything to do with extraction. It includes early-stage exploration, drilling, the transport of the raw material to the surface as well as operation and licensing of oil well and rigs.
- The midstream sector deals with transportation. Midstream companies operate pipelines, tankers, barges and trucks to get oil and gas from point A to point B. Additionally, they tend to have large storage facilities for the intermediate housing of crude oil.
- The downstream sector handles refining of crude oil and processing of natural gas. Output the final product that businesses and consumers use day-to-day.
- Integrated companies operate in all three of the above sectors. The most familiar energy companies like Exxon Mobil Corp. (XOM, Financial) and British Petroleum PLC (BP, Financial) fall into this category.
- Barrel of oil equivalent, or BOE,Ă‚ is the standard unit of measurement in the industry. In technical terms, BOE is a unit of energy equal to the burning of one barrel of crude oil. One barrel is equivalent to 42 U.S. gallons (even in countries using the metric system).
- The Three P's stand for proven, probable and possible reserves. They denote varying levels of confidence with regards to viable commercial extraction of oil. For instance, proven equates to 90% certainty, probable is 50% certainty and possible means 10% certainty.
Now that we understand the basic composition of the sector, we can discuss some unifying features of energy companies.
It’s all about the assets
A key feature of companies in the oil and gas sector that sets them apart from most other companies is their fixed assets are depleted and sold over time. Most businesses have fixed assets that may degrade over time, but this has little to no correlation with the amount of profit generated. By contrast, the main assets of an energy company - its reserves - are continuously sold off.
Another feature of these companies is they are extremely capital-intensive. This is partly a natural consequence the fact oil reserves constitute the main asset for most companies. But even midstream and downstream companies that may not directly own oil fields and wells tend to have large amounts of fixed capital in the form of pipelines, refineries, tankers, distribution centers and so on.
Oil and gas companies also tend have high levels of debt. Having large amounts of real physical assets makes it easy to issue bonds, as creditors know that even in a worst-case scenario they can be reasonably sure of loan repayment.
Factors affecting share price
One of the things that makes investing in this sector so difficult is the wide slew of things that can affect the day-to-day share price of an energy company. Obviously, the global price of oil, of which there are two main types - Brent Crude and West Texas Intermediate, is the main factor affecting profit margins and, therefore, the share price. Oil prices are determined by a wide range of levers.
The actions and statements of major oil producers like the OPEC countries and Russia can determine oil prices. Currently, this alliance has in place a deal to curtail production in order to keep the price high. Global demand exerts a massive influence on oil price, too. Signs of progress in U.S.-China trade talks are likely to be perceived very positively by energy producers, as the resulting economic strength will be very good for business. In this sense, a bet on the oil sector is also, to a certain extent, a bet on global economic growth.
A value investor obviously shouldn’t care too much about the day-to-day fluctuations in the oil market. But the important thing to recognize here is the price of oil, like that of most commodities, is cyclical. If you can identify a solid company using the methods that will be discussed in parts two and three of this series, a cyclical dip in the underlying energy market can provide an excellent opportunity to buy at value.
Summary
This has been an introduction to the oil and gas sector. The second part of this series will look at common valuation metrics for the sector, including a discussion of why the price-earnings ratio is often not an appropriate measure of value. In part three, we will take a deep dive into metrics that apply specifically to upstream companies.
Disclosure: The author owns no stocks mentioned.
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