Oil & Gas Primer
Companies involved in finding, extracting, refining, and distributing the commodity
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What is the Oil and Gas Industry?
The oil and gas industry, also known as the energy sector, relates to the process of exploration, development, refinement of crude oil and natural gas. It is possible to invest in this industry directly and indirectly. An investor can choose to purchase the commodity using the spot market or futures market. Or, the investor can invest by buying shares through the stock market.
Key Highlights
- The oil & gas industry includes all the companies involved in the process of finding, drilling, extracting, refining, and distributing the commodity.
- The industry comprises three categories: upstream, midstream, and downstream.
- Valuation methods include using discounted cash flow to find the net present value and industry-specific ratios such as enterprise value per flowing barrel.
How are Oil and Gas Prices Set?
Oil and gas prices depend on the supply and demand for the commodity. As the demand for the product falls, so does the price. As prices increase, more investment goes into drilling projects and inventing more efficient techniques. So, the supply for oil and gas is price-driven.
The Organization of the Petroleum Exporting Countries (OPEC) controls 75% of the reserves and 43% of oil production. Therefore, they exert a large influence on the supply and price of oil. On the other hand, segments of consumption drive the demand. The main segments are industrial consumption, residential consumption, and power generation.
Upstream, Midstream, and Downstream
There are three components of the oil and gas industry, one for each part of the value chain. Due to the complexity of each component, most companies focus on one.
Upstream
Another name for the upstream industry is exploration and production (E&P) since the industry finds and produces crude oil and natural gas. It also comprises of service companies that assist the E&P processes, e.g., rig operators, engineering and scientific firms, and equipment manufacturers.
Midstream
After the upstream industry finds and produces oil and gas, the midstream companies store and transport the products. Midstream companies work to connect the petroleum-producing areas to population centers where the customers are.
The connection is done through pipelines, rails, tankers, and trucks. Also, midstream companies possess the properties of upstream and downstream producers. For example, some companies own processing plants to remove sulfur and natural gas liquids.
Downstream
While midstream companies deliver products, the downstream segment refines, markets, and distributes the end product to consumers. End products include gasoline, jet fuel, heating oil, and diesel. The end products are dependent on the complexity of the refinery. Some are capable of producing multiple types to be in line with current demands.
Reserves and Resources
Oil and gas reserves and resources are volumes that might be commercially recoverable in the future. Reserves and resources are further categorized based on estimated volumes, which help determine the potential of a field.
The three categories of reserves are proved, probable, and possible reserves. Each category comes with a different probability of recovery. For example, the recovery rate of a proved reserve is 90%. On the other hand, resources provide less certainty relative to reserves. It is further split into contingent and prospective, with contingent resources offering more potential for recovery.
Valuation Methods for Oil and Gas Producers
Net Asset Value (NAV)
The net asset value or discounted cash flow helps determine the value of oil and gas producers. Most NAV is the present value of after-tax cash flows. To make the NAV calculation more reflective of actual value, it accounts for proven and probable reserves.
Trading Multiples
Trading multiples help investors compare the valuation of a company with their peers. Common multiples used are:
Enterprise Value per Flowing Barrel (EV/boe/d): determines the value of the company per barrel of production and helps investors compare the price of the company with the production volumes of the company
Field Netback: shows the margin created from a barrel of oil after subtracting standard costs and indicates the profitability of the asset without taking into account taxes and interest
Enterprise Value to Reserves (EV/boe): similar to EV per flowing barrel, but compares the price of a company with barrels still in the ground to determine the future potential of a company’s assets
Finding, Development & Acquisition (FD&A) costs: shows the cost of finding barrel reserves and producing it
Recycle Ratio: indicates the level of profitability of an oil or gas asset
Price/NAV (P/NAV): calculates how much an investor is paying for the underlying net present value of the company
Valuation Method for Oilfield Services
Discounted cash flow is not the typical evaluation method for service companies. Instead, common methods are EV/EBITDA, P/E, and sum of the parts. The factors that influence EV/EBITDA and P/E include growth prospects, risk profile, and strength of the leadership team. Sum of parts is suitable for a company that is involved in more than one segment of the oilfield service industry.
