Sunday, January 18, 2015

How To Evaluate Opportunities After The Oil Price Slump

I apologize to my readers for not writing in a very long time but I will try to write a couple of insightful posts within the next week. Please stay tuned. 
The biggest surprise in 2014, other than abnormal rally in the long term treasury market, was the 50% decline in crude oil price. Whenever I see a price decline of such large magnitude in a very short amount of time, I investigate to see if there are opportunities to pick up cheap stocks. Since I'm a fundamental based value investor, I only buy if I see the intrinsic value of the business significantly higher (>33%, preferable >50%) than the current price. Thus, I need to estimate roughly what the intrinsic value is. Note, I used the word roughly. No one can know exactly the value of the underlying business. I prefer to be "approximately right than precisely wrong". 

This article will explain the NAV model, the most widely used method to value oil and gas companies. Then, I will explain why I believe the key input of the model is flawed. Finally, I will share with readers my methods to evaluate oil and gas stocks.

NAV Models: 
Analysts and industry professionals use a NAV (Net Asset Value) model to determine the intrinsic value of an oil and gas company. The NAV model is just a variation of the commonly used DCF model. The NAV model discounts annual free cash flows until the reserves of the company reach zero to calculate the present value of the operations. The value of equity is the sum of the present value of operations and net working capital minus all outstanding liabilities (bonds, short term paper and decommissioning liabilities).

The Most Ridiculous Input: The Long Term Commodity Assumption:
The most ridiculous input, in my opinion, into analysts' NAV models is the"long term" commodity assumption. For oil and gas valuations, it is the long term assumption for WTI Crude Oil (Or Brent) and NYMEX Gas (Henry Hub). This long term assumption is often used for year 3 and beyond in the forecasting model, which will have a significant impact on the intrinsic value estimate since around 90% of the NAV model's value depend on the cash flows from year 3 and beyond.

How is this long term oil assumption determined? Using economic theory, a commodity like oil should trade around the marginal cost of producing one addition unit. However, many professionals discard this theory and place more emphasis on the current price. Succumbing to anchoring and availability biases, analysts input these inappropriate price assumptions into their models to justify their current price targets. I can't blame them for using current prices. It is much easier to justify your financial model in front of institutional clients by using an oil price that is not too far away from the current one. It is the most available snapshot of crude prices and a good anchor to use. However, I believe too many investors fall for this anchoring bias by focusing on prices that are easily observable.

When oil peaked at $147 in 2008, some analysts had $150 as the long term oil assumption. Conversely when oil bottomed at $32 six month later, the long term oil assumption dropped to near $50. The meaning of long term is probably 12 or 24 month in the eyes of the most analysts compared to the theoretical meaning of 30 or even 50 years down the road.

My Method of Valuing Oil Companies: 
How do I value an oil and gas company? Since I'm not an expert in that field and isn't an engineer, I pay extreme attention to what strategy players pay for oil and gas companies. The multiples in those transaction can be calculated and I use those multiples as a starting point to estimate intrinsic value. The trick here is to choose relevant transactions. For example, transactions in early 2014, when oil was well above $100, may not provide the correct intrinsic value multiple. However, a transaction that caught my attention was the $13 billion takeout of Talisman (TLM) by Repsol in December when oil was near $50. Despite the outlook for oil was extremely dire, Repsol decided it was time buy. The assets acquired wasn't high in quality and 70% of the asset mix was natural gas, which was extremely surprising to me. Nonetheless, the multiple paid , on an enterprise basis, was $50,000 per production (BOE/d) and $12 per 2P reserves (BOE).

Second, I try to look at potential hidden items on the balance sheet. One item I look for is land holdings that may possess resources that are not converted into reserves. Since analysts only model value based on reserves, potential future conversion of resources into reserve is one catalyst for higher share appreciation. This analysis is a difficult one but data is widely available for the discovered resources and reserves in major oil plays such as Montney, Cardium, Shaunavon, and Viking in Canada or Permian, Bakken and Eagle Ford in the US. Another balance sheet item is debt. Debt-heavy oil and gas companies have been hit harder than peers that have less debt. Nevertheless, every company's debt is different and it is wrong to evaluate a company's debt level purely on financial ratio such as Debt-to-equity or Debt to cash flow. The covenants should be examined to see if the debt is cov-heavy or cov-lite. The former is significantly different than the latter. A relatively debt heavy company is still a feasible investment if it has plenty of assets. The two options would be either sell certain assets or sell the whole company. Talisman had a lot of debt but it still managed to sell itself due to high quality assets in North American (outweighing the poor quality of its Asian and North Sea assets). The low valuation for Talisman was a bonus too.

With the transaction multiples and the balance sheet analysis, I can roughly estimate the intrinsic value of the company. The last step I do is a rough NAV model but with more realistic assumption for oil long term oil prices. Let's not forget the concepts taught in  Economics 101. In a perfectly competitive industry, the price of the good should equal to its marginal cost, which is about $70-80 for oil. As oil prices reach below the variable cost (cash costs in the oil business), firms will close down, thus bring the market into balance. In the long run, market forces will balance out so price will reach near marginal cost. The industry has already slowed down with the number of rigs in North American dropping to the lowest since early fall 2014 according to Baker Hughes data. However in the short run, prices can be extremely volatile. Hence, the balance sheet must show strong signs that the company can at least survive a low price environment (e.g. having a good hedge book) for the next year or two.

The rapid decline in crude oil price since June last year has created an excellent opportunity to pick up a few beaten down energy stocks. All oil and gas stocks were sold, regardless of quality, valuation or potential hidden assets on the balance sheet. Thus, there are definitely few good names to buy.

I adhere to my motto: "Misconceived risk equals opportunity, miscalculated risk equals fiasco" as mentioned in my previous article. Misunderstood risks create opportunities but I need to complete a full analysis to make sure I didn't miscalculate any risks.