In part two of this series, we dug into some commonly used valuation metrics for oil and gas companies and discussed their relative merits. We also explained why the price-earnings multiple is often not a particularly good measure of the success of an energy company. In this third and final part, we look at another set of metrics that are used to evaluate specifically upstream energy companies (for a recap of essential oil and gas terminology, check out part one).
What makes upstream companies stand out?
Recall that an upstream oil and gas company is one specializing in the exploration of new reserves and the extraction of crude oil from said reserves. As such, they have some special characteristics that go beyond those described for the sector as a whole.
First, they are affected by changes in the underlying oil price even more than mid- and downstream companies, as they are producers of the primary raw commodity. Second, their main assets are their reserves, which are depleted over time as the company generates more and more cash. Accordingly, upstream firms have metrics that are designed to specifically measure the value and production of these assets.
The metrics discussed below all use enterprise value. This is just the equity value (or market capitalization) of a company plus liabilities minus cash.
Why use enterprise value? Recall that energy companies tend to have high debt loads, and enterprise value includes the cost of paying this down (as opposed to just market capitalization taken on its own).
With that in mind, here are the metrics.
Enterprise value to earnings before interest, taxes, depreciation and amortization (EV/Ebitda): This is a superior ratio to price-earnings because it does not matter whether the company is financed primarily with debt or equity -- the ratio will be the same. A commonly used variation on this metric includes exploration costs within Ebitda (this is known as Ebitdax). A lower number is a sign of cheaper valuation.
Enterprise value to debt-adjusted cash flow (EV/DACF): As mentioned, oil and gas companies tend to be highly leveraged. As a result, the earnings they generate may be artificially depressed due to the cost of servicing this debt. Excluding interest payments from cash flow gives investors a more accurate measure of how well the company is doing -- a lower number indicates that the company is generating a lot of cash relative it its existing assets.
Enterprise value to barrels of oil equivalent per day (EV/BOEPD): This is a fairly straightforward metric that assesses production. The lower the number, the more barrels are being produced relative to the value of the businesses; therefore, lower numbers indicate cheaper value.
Enterprise value to proven and probable reserves (EV/P&P): Recall that proven reserves have a 90% chance of being eventually extracted, while probable reserves have a 50% chance of being extracted. EV/P&P therefore measures the expected future prospects of an oil company. Lower numbers indicate that the company is being valued cheaply relative to the amount of oil that it is likely to produce in the future.
Summary
This concludes this three-part series on the oil and gas sector. You should now have a good understanding of the structure of the oil market, the factors affecting share price and common metrics used in valuation across all parts of the energy sector. This should enable you to find hidden value, and also to avoid fraudulent companies -- a topic that we will cover in future articles. Happy hunting!
Disclosure: The author owns no stocks mentioned.
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