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Interview with an Oil & Gas Investment Banker: Part III

Interview conducted with an oil and gas investment banking associate in the Global Energy and Power/Natural Resources Group of a major investment bank

This interview ended up being excessive so we have cut it into 3 components to avoid reader exhaustion

Read Part I

Read Part II

Do you need an oil and gas background to work in oil and gas investment banking?

Yes and no. So unlike other groups in New York where you interview for a generalist position and are allocated into a sector or product after a post-interview sell day, you need to know oil and gas before your interview.

Because oil and gas is such a niche and technical industry, I would bucket it alongside healthcare as one of those industries where you would be much better served knowing the industry well beyond the average Joe before you start.

Do you prefer petroleum or chemical engineers or geologists?

Now this does not necessarily mean that you have to be an engineer or a geologist – there are a lot of petroleum engineers who are great technically but do not know the finance aspect (which is believe it or not important in investment banking) or know both but are probably about 10 years away in terms of social awkwardness. Same for geologists, except for right or for wrong we do not necessarily see geology as the most difficult degree, but they usually are mildly better in terms of the social aspect.

As a junior investment banker focusing on corporates, you do not need to know about porosity or permeability beyond a high level. If you start talking about pay thickness in an interview you may lose some people.

For someone new but with time to prepare for an oil and gas interview, can you spend some time getting them up to speed?

I think the most basic thing to understand is supply and demand. Oil and gas is as pure as you can get in terms of the concepts you can learn in Econ 101.

There are ~100 million barrels of crude produced each day and ~100 million consumed – this is the equilibrium balance. The exact numbers are obviously not pinpoint but conceptually this is what you need to know.

So looking at short term and long term, in the short term there are a couple of factors that are pushing the supply curve to the left.

What is going on with oil prices in the short term?

Iran is a geopolitical enemy of the U.S., who are using sanctions to achieve foreign policy goals. Other countries are not allowed to purchase Iranian oil, lest they get locked out of the US financial system. All things equal, this pushes the supply curve to the left. The new equilibrium means that you drive oil prices up.

Similarly, Venezuela is rapidly regressing to a failed state (you could very well argue that it is there already). In order to satisfy the Maduro regime (socialist dictator in charge), the petroleum engineers have been taking shortcuts to boost production figures temporarily. Oil production continues to decline while talent and expertise continue to flee. This is another negative for supply. Supply curve to the left.

As an offset, you have the ramp up of US shale production. Unconventional oil production and technology have advanced significantly, but it is simply not enough to offset the supply rollback. Likewise, Trump is pressuring the remaining OPEC nations to ramp up production to keep oil prices suppressed while Russians (another top 3 oil producer) continue to stimulate their wells.

On the demand side, Chinese and Indian consumption and economies continue to advance well beyond any developed economy – but this is a gradual climb versus an immediate demand push to the right.

You actually have a lot of supply shocks on the table as well. While Iraq is no longer really threatened by ISIS, Libya is a basket case and can see production drop at any time due to warring factions who often skirmish around export terminals.

What is going on with oil prices in the long term?

This is a far more interesting dynamic – and very bullish for oil prices assuming we do not find the philosopher’s stone via some electric vehicle breakthrough or a magical orb via the Avengers.

Over time, the China and India growth is very real – as is Africa, as they are buttressed by real Chinese infrastructure builds instead of foreign aid and sympathy. Africa is a rising power both as a collective and within indiviaul nations. If you ever stop by Addis Ababa or any other major city you will see incredible things happening in terms of construction and architecture. Certainly not the Africa that is marketed to you by World Vision, Red Cross or any of the farcical infomercials for bored housewifes at 3PM.

This pushes the demand curve to the right. Living standards pull towards what we expect in the West. All things equal this means higher prices.

Likewise, on the supply side, you have to understand that oil and gas is not a widget factory. The resources are finite, which means that if you do not spend on developing oil and gas assets the production will decline.

US shale oil is an anomaly within oil and gas (I should say shale and tight oil in general, except there has not been widespread oil and gas production from unconventional sources outside of North America for reasons ranging from the learning curve, NIMBYism to challenging geology) – only unconventional oil and the oil from the Middle East can be started up quickly with a short payoff period and certainty of getting the oil that you need.

A lot of production comes from megaprojects with very long lead times for construction. These megaprojects cost billions of dollars to start up and are declining fields. These are rolling off over the next few years and no one has the certainty of a high oil price to invest in such large capital commitments.

Once these roll off with no replacement production, the supply curve shifts sharply to the left. This really pushes up the price of oil.

Very interesting – what are the ramifications for Brent and WTI? Do students need to know about differentials for oil and gas investment banking interviews?

Now let’s briefly touch upon benchmarks. You guys have an explanation or two on your website but it is long-winded.

And yes they are very important to understanding oil and gas as an industry as they influence the actual realized price that the oil and gas companies get.

It is also another exercise in economics and they show how regional dynamics can deviate from global dynamics.

Brent is a global benchmark. When you discuss the price of oil broadly in a global context you are talking about Brent.

When you are talking about WTI, you are talking about oil in a North American onshore context. WTI generally trades at a discount to Brent despite being of a higher quality to Brent. This is because of a transportation differential. Brent is seaborne crude, WTI settles at a place called Cushing, Oklahoma. Oil can stuck at a hub in Cushing. Seaborne crude travels freely on the ocean in tankers.

From economics, you can expect that Cushing crude trades at the cost of transportation via pipelines to the Gulf Coast, which is where it more or less trades at the price of Brent. It’s that simple.

Right now the oil produced in the Permian has transportation bottlenecks in getting the crude to Cushing. As such, WTI Midland (same oil, different place) trades at a discount to WTI Cushing because it is hard to get it there. More economics. It’s that simple.

For gas, even more pure economics because natural gas here is natural gas anywhere. It is methane – unlike oil which has different grades.

What other factors feed into the price of oil?

Aside from a transportation differential there is also a quality differential. Crude is not an element. From science class in Grade 8, you learn that it is a mechanical mixture. Fundamentally, you want to transform part of it via distillation, amongst other means, into gasoline and other premium refined products via refineries.

Brent is a light crude. It has a high gasoline yield. At the risk of simplifying this, there are heavier crudes with lower gasoline yields (which means the refined products are of a lower quality on average) in addition to higher refining costs (if they are “sour” crudes and contain sulfuric content).

These inferior crudes by transitivity must trade at a lower value to Brent.

As such, you must always look at a transportation differential and a quality differential. Either one can be punitive, but transportation differentials can be a lot more punitive. For example, if a barrel of oil exists in Antarctica, you can expect it to trade at an extraordinary cost (maybe even negative) for you to transport it to a demand market.

That’s a very succinct explanation. Now converting this to an investment banking perspective instead of a sales and trading perspective, how do you value oil & gas companies?

To simplify, let’s focus on exploration and production or upstream oil & gas companies.

The most important intrinsic valuation approach is the NAV.

Now a lot of students make mistakes when we ask them how to value a company, and they think that they can say net asset value and we are impressed.

We are not impressed, and especially not impressed when they say a DCF and a NAV.

Let’s make a few things clear about the NAV – a NAV is not a unique concept to oil and gas or commodity companies. You can look at NAV for real estate, for conglomerates and for mutual funds. It is as simple as it sounds – it is net. asset. value.

Also, when you say that you can use a NAV or a DCF, what you do not understand is that in the context of oil and gas, a NAV is a DCF – or rather the aggregate sum of multiple discounted cash flows.

So let’s say there is an oil and gas company with 3 projects. You add the present value of the 3 projects to get your asset value. You add up the present values of these projects, that is your asset value. Subtract debt, add the present value of your hedges and subtract the present value of general and administrative (corporate) costs. Now you have your equity value. It’s that simple.

Can you break down the most simple oil and gas NAV?

Let’s assume there’s just one oil project – just one well or just one project (in reality projects have multiple wells).

What you are essentially doing is, assuming a certain oil/gas/NGL price, finding the present value of an oil and gas project.

Each well has a cost of $5 million of initial capital spend (CFI) and will generate 1000 barrels of oil in the first year, with production declining 20% per year.

The oil price realized is going to be $10 less than WTI and you have x, x, and x as operating, transportation and G&A costs per barrel, respectively. The realized oil price – a royalty and these factors equals your netback. You multiply the netback by the number of barrels produced per year. That is your operating cash flow for the year.

To maintain the production, you need to spend maintenance capex. Multiply that assumption by the number of barrels. Now you have capex/cash flows used in investing activities Now you have free cash flow.

Discount the cash flows by 10%. Done.

So for dummies, how do you differentiate an oil and gas NAV from a standard DCF?

Well for one, the assets are finite. There is no “terminal value” via EBITDA multiple or Gordon Growth Method because the assets are depleted to zero. Once you eat all the cookies the jar is empty.

Two, you are looking at the individual assets instead of the corporate, so corporate expenses are deducted after as a present value.

Three, there is no weighted average cost of capital concept. You treat all projects the same and discount them by 10%.

This naturally leads to two discussions – why is WACC not relevant and why do we use 10%?

Interestingly enough, both of these questions come up in interviews and there is NO INDUSTRY STANDARD ANSWER.

So either the interviewer has a bone to pick with their own personal philosophy or they are just looking to see your thought process.

This is my take for why WACC is not relevant. Energy stocks will track the price of oil far more than the S&P 500 – as such, any correlation between oil stocks and the S&P may actually be meaningless after running a multiple regression that incorporates the price of oil. As such, WACC is not a meaningful discount rate.

Why 10%? It seems like an appropriate return hurdle – that said, to get to the true hurdle for investors, there is no way an oil company in Kurdistan is going to be amenable to investors at a 10% discount rate. Although the NAV may be discounted at a 10% rate, the P/NAV multiple will be far lower to compensate for the geopolitical risk (although some analysts argue that Kurdistan is not that unstable).

What are some other common valuation methodologies in oil and gas investment banking?

Price/Cash Flow, FCF Yield and P/NAV are somewhat common. EV/EBITDA and even P/E can be used for very large, integrated oil and gas companies. You have so many projects coming on and rolling off for them and they are so diversified that you just take earnings as a smoothed figure unlike the very lumpy nature of smaller E&Ps.

Secondary metrics that tell a story but should not be looked at as a standalone include EV/production, EV/reserves.

For all the major plays in the US, we will also track price/acre for land sales. Acreage in the Permian is ridiculous right now at $90,000/acre in core areas – EV/Land.

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