Are you interviewing for oil and gas investment banking (or any other energy finance related job – corporate banking, commercial banking/reserve based lending, commodity sales, corporate development, treasury)? You should always expect these questions to come up. This guide assumes a basic understanding of energy – we will not be explaining all of the acronyms and terms, but a more detailed expository is available in our various energy posts and the main pages for:
- General Energy
- Upstream/Exploration & Production
- Midstream/Pipelines and Energy Infrastructure
- Downstream/Refining & Marketing
What are some common multiples to use for oil and gas?
EV/DACF, EV/EBITDAX (or adjusted EBITDA), Price/Cash Flow and P/NAV. For supermajors such as Exxon or Shell, some analysts will use Price/Earnings as they have a diversified enough earnings stream to make up for the lumpiness of cash flow from one major project.
What is DACF and why do investment bankers use it?
DACF stands for Debt Adjusted Cash Flow and it is calculated via cash flow from operations (CFO) adjusted for working capital plus after-tax interest expense plus exploration expense. CFO adjusted for working capital is basically funds from operations (FFO) or operating cash flow.
DACF is used because it is a pre-leverage metric or independent of capital structure – as such you are valuing the assets. This is very key because a lot of energy M&A is done at the asset level as opposed to the purchase of an entire company. However, note that DACF is post tax – reflecting the differences across jurisdiction in taxation that may be independent of leverage.
For smaller companies, you rarely pay cash taxes because of the credits they earn from drilling so it sometimes just ends up being OCF + after tax interest.
Why do investment bankers use EV/EBITDAX?
EBITDAX is earnings before interest, depreciation, amortization and exploration expense. EV/EBITDA is used broadly as a pre-leverage valuation metric and EBITDAX just adjusts for exploration expense, which does not reflect the cash flow generation of the firm – exploring can be stopped.
Walk me through the NAV model.
Realistically, the bare bones are that you value all of the assets separately and then add in corporate effects.
- Find the present value of cash flows from existing producing assets by assuming no new exploration and depleting their reserves to zero – sum up these asset PVs – this is your Asset Value
- Subtract claims to other stakeholders and other corporate effects – subtract net debt (debt minus cash), subtract the present value of decommissioning liabilities (to clean up and plug the sites when production is done), subtract the present value of corporate costs (sales, general and administration), add the value of the hedge book (the hedges the oil and gas company has in place – this can make a big difference)
For the assets that the company has, assume that there is no new exploration and the assets are depleted to zero. You have to ascertain the after-tax cash flows less the maintenance capital expenditures required to keep the oil production going.
The after-tax cash flows have a known and unknown component – the price that the company realizes is dependent on the benchmark price of oil less the discount it realizes against the benchmark. This means that the top line of your calculation is dependent on your oil price assumptions. If you use a dated equity research report where they assume the long-term price of oil is $45 when WTI is currently at $70 you are going to look stupid.
From there, you subtract royalties (which are dependent on the price of oil) and operating expenses (which usually are not) to get to a unit netback or unit profit per barrel. This is subject to cash taxes which will yield an after-tax cash netback. Tack off the capital expenditures per barrel and this will be the cash flow per barrel.
Multiply the cash flow per barrel by the forecasted production until reserves are depleted.
This is the asset value. Subtract debt, add cash, subtract decommissioning liabilities, subtract the present value of corporate expenses and add or subtract the value of the hedge book. The hedge book makes a big difference – for instance, if oil is at $30 and the company hedged out most of its production at $85/bbl, this is going to be a tremendous cash flow to the company. Long term, if the company is a high cost producer, they are still going to get dinged from a valuation perspective.
Without someone from inside the industry explaining this to bankers, it can be extremely confusing – even when looking at equity research reports because none of them will have a consensus NAV standard in calculating their price targets. Some analysts will use a 2P NAV, some analysts will use a 2P NAV with risked upside, or any other variation.
Despite requiring an understanding of NAV, in practice bankers will grab a NAV from their equity research team or plug in numbers from reserve engineers to spit out a figure.
Why do we discount cash flows at 10% per year?
When looking at research reports, you will often see the figure PV-10. This is the present value of cash flows discounted at 10%. Why is it 10%? There isn’t necessarily a good reason – but it is the industry standard. Different people will give you different answers so make something up that sounds good.
For instance, since oil does not necessarily move with the economy and market, the return on equity for WACC may be a meaningless measure as based on historical regression. As such, you may look at an oil company as a project specific investment whereby the ROE should be based on the riskiness of the cash flows (depending on jurisdiction, geological risk etc.) as opposed to the market.
In theory, this means a larger discount rate for assets in Libya as opposed to the Montney – in practice, everyone uses 10% but the P/NAV that the Libyan assets will trade at will be a lot lower.
What is going on in the oil macro? What is going on with oil prices here? What is going on with the pipelines?
This is important in demonstrating that there is a genuine interest in the industry as energy industry groups in North America are located away from the main hub (Houston and Calgary as opposed to New York and Toronto). Candidates will be expected to speak intelligently about how the oil price has gotten to where it is over the last few months and years and where they expect it to go in the next few months and years – supported by macroeconomic news and a logical explanation of the incentives of players in the oil market.
For regional markets, knowing what happens to the barrel of oil over there is important as well. In Houston, the differential between Brent and WTI should be explained (the cost of transportation to tidewater) and which plays are doing well (the Permian is always doing well). In Calgary, candidates will be expected to know where the WTI-WCS differential is (which may include speaking to the current egress issues with pipelines) and what the AECO basis is and why.
Pitch me an energy stock.
Beyond having a price target and saying they have low costs, energy bankers will almost certainly know the peer group well and you may be expected to dig deeper than just reading the latest Seeking Alpha post on a random energy company.
If you name a price target, you have to have a reference price deck – or at least a long term price of oil in mind.
If you say that a company is low cost, you may be asked about what the netback is and how this compares to peers.
Bankers and energy investors are generally very interested in the strength of management and how aligned they are with shareholders – this is very important from a capital discipline and execution perspective. For smaller start-ups, investors care about previous ventures the management teams have brought up and what they managed to exit at.