Written by an oil and gas analyst in a Bulge Bracket investment bank
Metrics & Multiples Analysis: Oil and Gas
Metrics and multiples are a key dimension of valuation within Investment Banking and Equity Research (and corporate banking). Each metric/multiple tells a different story about the current state of the business. Analysts leverage different metrics/multiples to help determine what the business should be worth and how the business is performing relative to other businesses.
Oil and gas investment banking analysts have to update the comparable companies database or “comps” whenever there is new information – whether it is periodic financial reporting such as quarterly or annual disclosures, or when acquisitions or other events occur that will change production or the reserve base. This allows for the latest data for client presentations at any given time.
Usually, the comps file will be one very large Excel file with each company having its own tab. A summary tab will pull data from each of the company tabs to show all of the peers in a table where they can be easily compared – this is standard across most industries.
Where oil and gas differs is that the cash flows (and theoretically reserves/resources too – although they are remarked at year end via engineer reports) vary greatly depending on the underlying macroeconomic factors. While costs can be easily ascertained from company guidance, the actual revenues will depend on the price of the relevant oil and gas benchmarks (WTI, WCS, Brent), natural gas benchmarks (NYMEX/AECO) and the exchange rate/FX if assets are primarily out of the US. FX can be confusing for analysts new to the oil and gas industry – as oil is a global commodity that trades in USD, an appreciating USD is generally good for the oil producer.
As such, comps will be run at current strip prices and the broker’s price deck for equity research purposes, as well as at varying other price decks (bull case or optimistic case and bear gas or pessimistic case – sometimes credit functions such as corporate or commercial banking will have a stress case or worst case scenario).
Oil & gas investment bankers will take the underlying assumptions pertaining to oil production volumes and realized differentials, but implement their own price deck depending on what story the client wants to convey.
Comparables at current strip pricing
Strip pricing refers to the average of the daily settlement prices for futures contracts over a specified period of time (i.e. 12 months). This is not necessarily a good indicator for where resource prices could be at the specified time into the future, but theoretically a producer could hedge all of its production and get guaranteed pricing.
This would allow management to better decide if there is a need to hedge – especially if they cannot afford a price below strip pricing that is feasible (a new oil project needs $50 oil to hurdle while Strip is at $55 – the producer may choose to lock in at $55).
Comparables at broker’s oil price deck
Broker’s price decks are often used by analysts so there is an agreed upon forecast price and estimate for future resource prices from a credible source. However, broker price decks may be 1) outdated and not reflective of new market conditions; and 2) a price point that an analyst fundamentally disagrees with. Usually when the broker deck is too optimistic, that is when problems arise.
These prices can reflect the broker’s short term and long term views. Analysts make take averages of many price decks to get a better idea of what future resource prices may look like.
Oil & Gas Comps including hedges
Comps with hedging are important as they show what the company is actually doing in real time with regards to their profitability. It also highlights management’s ability to properly predict/manage risks.
If oil prices are locked in, forward looking figures with hedges will give a good indication of what cash flow analysts can expect. If oil prices fall substantially, cash flow measures will not fall that much as only the unhedged portion is vulnerable.
However, since hedges are short-term (usually not exceeding 12 months and rarely exceeding 24 months), bad assets in a falling oil price environment will still depress the stock as analysts know that in the future, they will not see the same cash flow.
Oil & Gas Comps excluding hedges
Comps excluding hedging are also important to analysts as they show a different story. Often times analysts like to look at comps excluding hedging so they can compare a more apples-to-apples comparison with regards to the operational performance of the business, excluding the interference of management. Hedges do not show a proper comparable story as different management teams may take on different risk mitigation approaches; looking at comps excluding hedge neutralizes this.
Valuation Multiples for Oil & Gas
Once an appropriate price deck has been chosen, analysts commonly cite these metrics:
The fundamentals of EV/EBITDAX are very similar to EV/EBITDA in that it’s meant to determine the firm’s true earnings, before interest, tax, depreciation, and amortization, relative to the size of the firm. This is set to determine how over/undervalued the business is relative to its peers.
EBITDAX stands for earnings before interest, tax, depreciation, amortization, and exploration expenses, and it is incorporated to normalize for the treatment of unsuccessful explorations between successful efforts and full cost accounting within the oil and gas industry. In successful efforts accounting, unsuccessful explorations are expensed, where as in full cost accounting, unsuccessful explorations are capitalized and added to PP&E. If EBITDAX was not used, EBITDA would seem higher on firms that use full cost accounting, however this would not be fully reflective of its true earnings as it is distorted by different accounting standards.
EV/DACF is another popular financial valuation ratio in the oil and gas industry. DACF stands for Debt-Adjusted Cash Flows and it represents the cash flow from operations with after-tax financing costs, pre-tax exploration expenses, and any changes to working capital. This ratio is effective as capital structures within oil and gas firms can differ dramatically and utilizing a DACF multiple neutralizes the effects of leverage.
Within the oil and gas industry, analyzing production is helpful in determining the firm’s value – basically this is a measure of how much the company is worth per flowing barrel of oil equivalent.
Revenue can be a misleading indicator as revenue can fluctuate and more often than not, it reflects the volatility in commodity prices rather than the operational performance of the business.
Looking at EV/Production allows analysts to understand the firm’s size relative to how much barrels the firm is extracting from the ground. Higher multiples can imply the firm is trading at a premium and lower multiples can imply that the firm is trading at a discount – however, certain barrels of oil are worth more than others. For instance, if an oil company produces light oil that is very low on the cost curve, the price per flowing barrel should be higher than a high cost oil sands producer. Also, oily assets are worth more than gassy assets as oil is priced higher than an energy equivalent amount of gas, so a gas producer should trade for less per barrel of oil equivalent of production.
P/NAV (Net Asset Value):
P/NAV can be referred to as Market Capitalization/NAV or Price per Share/NAV per Share. It analyzes the firm’s market equity value relative to the net asset value. The net asset value represents the net present value of all the future cash flows of the producing asset less net debt. Different firms may use NAV differently and some common cases include Core NAV, Risked NAV, Unrisked NAV, etc.. If this multiple is high, it may imply that the stock is overvalued.
Of course, in determining the NAV, the price deck used will cause the NAV to vary greatly – as such, despite being a very quantitative figure, it is heavily dependent on its underlying assumptions.
P/Bluesky NAV’s fundamentals are similar to P/NAV, however it instead looks to incorporate the unrisked value. The Bluesky NAV looks at the Risked NAV and adds in the incremental value that the company may realistically obtain, but may not yet be solidified enough for investors to pay for today. The idea of the Bluesky NAV asks the question how much should investors realistically pay for “future potential” today, and the P/Bluesky NAV looks at what the valuation multiple would be with the upside potential incorporated.
P/CFPS (Price/Cash Flow Per Share)
P/CFPS is always a popular multiple as it looks at the price investors are paying per share for the business relative to how much cash flow the company is generating per share. This is an important metric as oil and gas industry investors often value the amount of cash the business is actually generating instead of earnings.
It is important to be cognizant that this multiple may run into issues when companies have high leverage in their capital structure, which may distort the true operational performance of the business. Higher leverage means higher interest payments, which reduces cash flows, creating a higher CFPS multiple.
Interestingly, analysts rarely use Price/Earnings as a valuation metric for oil and gas companies due to the differences in cash flows and earnings for the capital intensive industry. However, sufficiently diversified supermajors such as Shell and Chevron can be viewed from a P/E lens.
Oil and Gas Credit
Net debt/EBITDA is an important multiple as it looks at the company’s total debt obligations net of cash, relative to its earnings before interest, tax, depreciation, and amortization.
Higher net debt/EBITDA multiples may be problematic as either the firm is over-levered, or it may not be generating enough earnings to service its debt obligations. Lower net debt/EBITDA multiples are usually more desirable.
As oil and gas is a cyclical industry, leverage multiples are expected to be much lower than cash cows such as real estate.
Although this is primarily a credit metric as opposed to valuation, equity brokers usually will also include Debt/EBITDA in the comps as it shows whether or not the oil and gas producer falls within a range of acceptable leverage that fits an optimal capital structure (not too levered) – which will flow through to valuation.
Bank Debt vs. High Yield Debt vs. Revolver – Debt Capacity and Liquidity in Oil Producers
Due to the capital intensive nature of the oil and gas industry, high leverage is quite prominent amongst players within the space if commodity prices tumble after they take on too much cheap debt. As such, analysts must be cognizant of the debt outstanding and when it comes due as oil and gas markets being as cyclical as they are will run into fundraising problems if prices are low and leverage is high.
Bank debt usually has lower interest rates than high yield debt. The interest rates for bank debt are usually also floating based on LIBOR and Fed interest rates, whereas high yield debt usually holds a fixed interest rate. Bank debt is also usually shorter tenor in the capital structure, which means they must be watched as they may come due in the near future if there is stress.
Bank debt usually holds maintenance covenants (must maintain minimum financial performance), whereas high yield typically holds incurrence covenants (inability to do something). With regards to repayments, bank debt is usually amortized, and high yield is typically a bullet maturity, where the entire principal is paid off at the end.
Creditors that issue bank debt have a higher claim to a company’s assets, given insolvency, than high yield issuing creditors as they have more seniority within the capital structure. Both bank debt and high yield debt can be used simultaneously and as they have different features, management often evaluates the best type of debt to use given their strategy.
A revolver serves as a line-of-credit and it is similar to bank debt in that it has low interest rates. It differs in that the revolver amount is not incorporated into a company’s total debt, unless the revolver is drawn upon. The revolver is a portion of money that the company can easily access so that management can better run the business, make decisions, and execute if needed.
Oil and gas company liquidity is very important for credit – companies with ample cash and credit lines will be OK with losing money for a certain period of time – they can afford to ride out a downturn. Companies that do not have access to liquidity while having upcoming maturities are in trouble and may need to be restructured – terrible for the equity.
Valuation Drivers for Oil and Gas
Knowing the oil and gas metrics that are used for comparables, these other quantitative factors can determine why certain companies trade at higher multiples than others.
Natural Gas Weighting
As mentioned above, gas weighted assets tend to trade at a lower multiple for EV/production and EV/reserves than oil weighted assets as oil is more expensive on an energy equivalent basis.
Natural gas is measured in volumes and is usually denominated in cubic feet. A thousand cubic feet may be referred to as Mcf, a million cubic feet may be referred to as MMcf, a billion cubic feet may be referred to as Bcf, and a trillion cubic feet may be referred to as Tcf, etc.. 1 Barrel (1 bbls) of oil is equal to 6 Mcf, 1 Mbbls is equal to 6 MMcf, and so forth. If analysts convert oil units they get BOE (barrels of oil equivalent) and if they convert gas units, they will get Mcfe (thousands cubic feet equivalent).
This is important as producers may report their reserves differently, and in order to compare apples-to-apples, it needs to be converted to BOE or Mcfe.
Percentage of Production Hedged
If a company is hedged while oil prices are falling, this is real cash flow that they will realise over the next 12-24 months. As stocks are the present value of earnings or cash flow, this is good for the share price. Likewise, if an oil company has hedged while prices are falling, this is a real cash flow that they have to pay out.
Hedging is an important part of the oil and gas industry due to the volatile nature of commodity prices. Many producers may choose to secure future oil and gas prices for certainty in exchange for potential future upside if markets were to improve. Many producers may choose to hedge portions of their production to guarantee a certain level of profitability, while at the same time leaving room for potential upside if oil prices recover in the future.
Production growth is a critical aspect in determining the firm’s development as it represents better usage of assets and better conversion to revenue growth.
However, production growth is also one of the most misleading metrics and should not be looked at as a standalone. Production growth is an eye catching number that companies will talk about while glossing over other important aspects to running an oil and gas company – to the point where analysts may deride it as “production at any price”.
If companies are spending too much to grow production instead of cash flow, this is meaningless and destroys value for shareholders.
The recycle ratio measures the profit per barrel of oil relative to the total cost of finding and extracting that barrel of oil. Higher recycle ratios indicate a more profitable and more efficient operation.
Paired with the recycle ratios, production growth becomes a much more meaningful figure.
The recycle ratio is usually calculated as the cash netback per barrel divided by finding, development and acquisition and extraction costs – however, the underlying method behind the finding and development should be scrutinised. If there was a major acquisition done on the cheap, this is a positive development but may not reveal the organic growth of the original assets.
Recycle ratios are looked at short and long (3-year or even 5-year averages) term to make sure any one year is not an anomaly.
Oil & Gas Cash Netback
A netback is a critical measurement of the profitability and efficiency of an oil and gas producer. It looks at all the costs associated with bringing one barrel of oil to market and all the revenues generated from the sale of that barrel of oil.
A netback takes in the revenues generated from the sale of a unit of resource and subtracts, on a per-unit basis, any royalty expenses, operating expenses, transportation costs, and processing costs. Gains and losses on hedging may be included in the netback and that amount would equate to the operating netback post-hedging.
Reserve Life Index
The Reserve Life Index (RLI) is another critical measurement that plays into a producer’s valuation. The RLI looks at the firm’s production relative to the amount of resources it has in the ground and helps determine approximately how long the reserves will last, given current production and no additional reserves.
A higher RLI generally means a higher quality asset as it lasts longer. However, there are use cases where this may not hold true. RLI can be higher due to lower current production, and that may be a reflection of an inability to extract resources out of the ground, rather than having a large resource base. Analysts are usually cognizant of this and will look at a producer’s production and reserves relative to its peers to get a better understanding of the full story.