TSXTrader.com – Canadian Stock Tips

Anyone who regularly follows my blog knows that my primary focus is on oil and gas producers. This is for several reasons. Firstly, 43% of the World’s Oil and Gas companies list on the TSX. Secondly, both my Bachelor of Commerce and Masters of Science focused on oil and gas related studies. Finally, I have worked in the industry since 2005, both domestically and internationally, allowing me to better understand companies in the sector and recognize quality operations.

To enhance my analysis of oil and gas explorers and producers (E&Ps), I have researched the most common valuation methods for energy firms, and summarized them below.

There are three main methods for providing valuations: discounted cash flows, comparables, and ratio analysis. One of the problems with oil and gas company valuations is that much of their value may come from reserves, which may not be accounted for using methodologies common to other industries. As explained below, a main question becomes how a company will be able to turn reserves into production and why cash from operations is so important to do so.

Net Asset Value (NAV)

This is a time consuming calculation and is basically the discounted cash flow of all the company’s assets less net debt. The reason it’s difficult to calculate is that one needs to estimate production and commodity prices and discount that future production back to present values. This can mean developing well type curves (estimates of future well production due to natural declines) along with predicting future drilling activities, the effect of enhance oil recovery (EOR) programs, or other forms or workovers, and building a model to discount the expected  future production back to present values. You then must deduct operating costs, royalties, and cpaital costs to determine the net operating cash flow. I have built these models in the past and can confirm that they’re often time consuming and tricky to nail down. Analysts are also able to gain additional guidance on the input numbers and although this is often available to the public in some fashion, it takes a lot of time and energy to research and find this information as an individual investor. I therefore tend to rely on sell-side analyst reports for NAV calculations, but these can be difficult to access unless you have good contacts or access through work.

P/NAVPS

Once you have a NAV value, you can calculate the NAV per share and see how much of a price premium is being given to the stock. This may help you recognize undervalued / overvalued stocks, or at least help you focus on why certain companies are receiving price premiums while others are not. Strong growth, large dividends, strong management teams, or take-over prospects may all place a premium on a company’s share price and it becomes your job  to determine if the premium (or discount for negative prospects) is reasonable or if there is an opportunity available. 

Price to Cash Flow (P/CF)

This is simply share price / cash flow from operations (less exploration charges). It is often a better metric than earnings as it is less easily manipulated, since the effects depreciation, depletion, ammortization, deferred taxes and other non-cash factors are removed. This also helps compare foreign companies from the same industry, since accounting for depreciation can vary across jurisdictions. The only issue is that it can be misleading if a company is abnormally leveraged compared to peer companies.

Price to Cash Flow per Share (P/CFPS)

 The P/CF per share amount should be based on the weighted average number of outstanding shares (fully diluted is the most accurate). It may also be smart to use a 30 or 60 day average share price in order to limit price volatility.

EV/DACF

This is a key valuation metric as it is an after-tax value (important given how much tax impacts returns in the O&G industry) and is independent of capital structure (important given how much companies differ in structures). Companies which employ higher levels of debt show better cash flow per share numbers.

Enterprise Value (EV) is a simple calculation whereing you take the market cap of a company plus debt, minority interest and preferred shares, and minus total cash and cash equivalents. To better understand EV, think of it as a company’s takeover price. In the event of a takeover, the acquirer would have to take on a company’s debt, but would also take the acquiree’s cash. 

Debt Adjusted Cash Flow (DACF) is simply the cash flow from operations + financing costs (after-tax) + exploration expense (before tax) +/- working capital adjustment.

EV/BOED

This may also be called ‘price per flowing barrel’ and is simpley the EV / barrels of oil equivalent per day. Of course, this metric does not account for reserves. It may also be a poor indicator at times when natural gas and oil prices are nowhere near their energy equivalents of 5.8:1, which is what is used to determine BOE. Therefore, it’s important to consider a company’s energy mix when using this metric to compare companies.

EV/Reserves (or EV/1P, EV/2P, EV/3P) 

This metric should only be used to compare companies of similar standing. i.e. Operating in similar basins and with similar exploration / development / production portfolio/ This ratio is easy to calculate and does not require any estimates or assumptions, since companies are required to report reserves based on strict engineering principles. It is also useful to calculat the ration on 1P, 2P and 3P reserves to determine the likelihood of development. I tend to prefer 1P and 2P for my evaluations, given that possible reserves only have a 10% chance of being produced.

1P = Proved Reserves = P90 = 90% probability of being produced

2P = Proved + Probable Reserves (Probable = P50 = 50% probability of being produced)

3P = Proved + Probable + Possible Reserves (Possible = P10 = 10% probability of being produced)

EV/EBITDAX

EBITDAX stands for ‘earnings before interest, taxes, depreciation and amortization and exploration costs’. EBITDAX helps equallize successful efforts and full cost accounting, wherein successful efforts accounting immediately expenses dry hole costs and capitalizes successful efforts and the full cost method capitalizes all exploration whether successful or not. The calculations for both accounting methods are below.

EBITDAX (Full Cost Accounting) = Operating Income + Depreciation, Depletion and Amortization + Accretion of Asset Retirement Obligation + Deferred Taxes

EBITDAX ( Successful Efforts) = Operating Income + Depreciation, Depletion and Amortization + Exploration Expenses + Dry Hole, Abandonment and/or Impairement Expenses + Accretion of Asset Retirement Obligation + Deferred Taxes

This metric is beneficial as it is unaffected by a firm’s capital strucutre. For instance, if a company is highly leveraged, the P/CF ratio would be low, but the EV/EBITDAX ratio will make it appears average or rich. A low ratio indicates a company may be undervalued and is often used to identify takeover candidates. Another benefit of the metric is that it ignores the distorting effect of taxes in various jurisdictions, making it useful for transnational comparisons.

Recycle Ratio

This ratio is an important measure of profitability. The higher the ratio, the higher the profitability. To calculate, you simply divide the profit per barrel (netback) by the cost of discovering and extracting the barrel (F&D or finding and development). These costs often vary significantly depending on the jurisdiction in which they’re found (i.e. it’s often much cheaper to operate in third world countries than developed countries, but with more political or security risk) so it should used to compare firms operating in comparable regions.

Reserve Life Index

The RLI is simply the quantity of proved developed reserves divided by annual production to determine the depletion ratio. For example, if a company has 10 MM boe in reserves, and is producing 5k boed, their RLI is 10 MM / (365 x 5,000) = 5.47. The depletion rate would therefore be the inverse, or 18.25% per year.

Reserves Replacement Ratio:

This ratio measures the amount of proven reserves added to a company’s reserve base during a year compared to the quantity of reserves produced (=Reserves Added / Reserves Produced). For a company to grow (or stay in business, for that matter), it should be adding more proven reserves than it is producing. It is also important to look at how a company is adding its production and whether it is just purchasing new reserves or through organic means.

Organic Replacement Ratio:

Following the above, the organic replacement considers the qunaity of reserves added through exploration and development rather than acquistiions. To calculate the organic replacement ratio, one simply removes the
reserves added through acquisition. The calculation is therefore = (Reserves Added – Reserves Added through Acquisitions) / Reserves Produced.

Conclusion:

To conlcude, no single ratio can independently direct your investment decision, but when used together they can be a very useful tool for recognizing value in a company.