I believe the oil-to-gas ratio is one of the best reserve metrics for analyzing energy exploration and production (E&P) companies. This week I will describe other important reserve metrics that can help you to decide whether an oil stock is overvalued or a a slick bargain at current valuations.
The chart below shows you how I analyze E&P stocks with different types of reserve metrics:
Proved Oil Reserves
(BOE stands for “barrels of oil equivalent.”
Click the image to see it full-size.)
The study comes from a 2012 Special Report in which I analyzed 2011 reserves for E & P companies that I follow. It shows you some examples of the companies I follow.
The third column shows each company’s "Proved Oil Reserves." This term has a very specific definition. According to the U.S. Securities and Exchange Commission, proved oil reserves are:
"[T]he estimated quantities of crude oil, natural gas and natural gas liquids which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible from a given date forward, from known reservoirs and under existing economic conditions, operating methods, and government regulations prior to the time at which contracts providing the right to operate expire, unless evidence indicates renewal is reasonably certain."
I explained the other reserve metrics in Energy Values article last month.
Here is another important metric investors should consider when analyzing E&P companies …
2 Big Buy Signals for Energy …
In yesterday’s Uncommon Wisdom Daily, James DiGeorgia told you how Europe’s recent interest-rate cut is a big buy signal for energy stocks.
But rumblings coming from its neighbor to the East — specifically from its power-hungry dictator — is an even-more-urgent reason to get ready to scoop up bargain energy stocks.
Enterprise Value Per Barrel and
F & D Per Barrel Costs (2011/Average)
Enterprise value is essentially the market value (shares outstanding times current price, or the cost to acquire the company) plus long-term debt divided by its proven BOE.
To calculate the debt, I use all the long-term debt and liabilities minus short-term debt. I don’t add the short-term debt, as I also look at the current ratio and it is normally a wash. This is a conservative way to value reserves.
Some analysts would argue that the market value of reserves is not a good measure of valuation because producing those reserves requires time and money.
I believe the valuation is not only fair, but also conservative. It does not include possible and probable reserves. For some companies, they would take valuations down to about $5 a barrel. It also excludes potential new discoveries and higher oil prices in the future.
The chart shows you the top 10 companies with the cheapest market value for their reserves. The companies with the cheapest reserves, excluding Canadian oil sands, and with oil-to-gas ratios over 50% are Swift Energy (SFY), Denbury Resources (DNR), Marathon Oil Corp. (MRO), Hess Corp. (HES) and Berry Petroleum (BRY).
Earlier this year, Linn Energy (LINE) acquired BRY for about $30 BOE, more than double the 2012 cost of its reserves. Most of these stocks were very cheap in 2012.
I will update this analysis and issue a new Special Report by May 2014.
Finding & Development (F & D) Costs
Currently oil is slightly above $100. I think over time it will surpass its all-time high of $147. Some companies like HES and Occidental Petroleum (OXY) have other significant operations that overstate the market value of their reserves.
The next table shows five companies with the lowest finding and development (F & D) costs.
This metric tells us about management, margins, profits, cash flow, drilling success and other fundamentals. These tend to be the Wall Street favorites.
I think the reserve metrics are more important: E&P companies are asset stories; earnings growth is less important for them. I want to own access to valuable, essential, depleting oil reserves.
Identifying F & D costs can be difficult. I had to use the company income statements and some provide average costs only over a three- to five-year period. The comparisons may not be apples to apples. For example, some companies have low costs because high natural gas reserves bring down their costs compared to oil reserves.
When I began analyzing these companies back in 2004, average F & D costs were about $6. Since then, F & D costs have gone up almost fourfold to about $22.80 on average. One reason is that oil prices have gone up. In 2004, oil was around $30. With Brent now about $110, F&D costs are proportionately higher.
The next table compares enterprise values and F&D costs for the periods in my previous studies:
Let’s review the table:
- Notice how enterprise value is less than F & D costs. It is cheaper to buy these stocks than go out and actually "find and develop" your own oil.
- The gap between enterprise value and F & D costs was much bigger in 2006. The energy story had not caught on back then.
- E & P companies were a bargain in early 2012, with their market value cheaper than their costs. Their reserves sold at a discount, $17.80 to buy versus $22.80 to find and develop.
Reserve Life Years
To find the reserve life of the companies on this list, I simply divide their proved reserves by current production. This tells us how many years it will be until the company runs out of oil and gas.
Of course, we have to assume production and proved reserves will remain the same, which is a big "if." The number is most for comparing peer companies against each other. We want to own companies with a long reserve life.
The list shows the companies with the highest life reserves in years. Suncor Energy (SU) proved reserves should last about 12.5 years, but including its probable and possible reserves extends the life to about 35 years.
You might ask whether these reserves will go down over time as the companies produce and sell them. They would, but not if the company replaces their reserves. The next chart shows replacement percentages of some of the E & P companies I follow.
Energy stocks are by their very nature "depleting assets." Every barrel of oil that comes out of the ground reduces that company’s value. The best companies to own are those that replace reserves as fast as or faster than they produce/sell.
Let’s review the table:
- I listed the companies with the highest replacement ratios first because I want to see a high replacement percentage.
- Smaller companies tend to have the highest replacement percentages. They begin with a smaller base, so naturally they have higher replacement values.
- Company can increase their reserves in several ways besides exploration. They can also convert possible or probable reserves to "proved" status … buy from competitors … apply new technologies … or find better management, engineers and other professionals.
- The average replacement for the group is 261.34%
The Real Potential
The last, bottom-line question: If these companies keep replacing their reserves, how much potential do they really have if we include their probable and possible reserves?
My final table shows some of the companies I follow and compares their proved reserves to their total proved, probable and possible reserves.
(Click the image to see it full-size.)
For this purpose, we define "probable" reserves as those with a 50% confidence level of being produced. Possible reserves have a confidence level between 10% and 50%. Here is what the list tells us:
- Some companies don’t include their probable and possible reserves. So I excluded them from the list.
- The total reserves for every company on the list are 65.78 billion BOE. Many of those reserves are outside the U.S.
- The average amount above proved reserves is 121%, and the average proved reserves for companies on the list is 20.4 billion barrels. That means their total potential reserves are about 44 billion BOE. Remember: About half the reserves are natural gas, so that brings us back to 22 billion barrels of oil.
- As I said above, many companies list reserves as liquids and natural gas. Liquids include oil and NGLs. Again, this makes apples-to-apples comparison difficult. NGLs sell for higher prices than natural gas, but not as much as oil.
After I go through this reserve analysis, the E & P stock bargains begin to stand out. I plan to issue my next E & P Reserve Special Report around May 2014. This article is for educational purposes.My goal is to show you how I value companies using their reserve metrics. I don’t currently recommend buying any of the stocks I’ve named.
Analyzing natural gas companies is a different process. I’ll tell you more about it in future columns.
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