Analysing... Oil companies

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A barrel of crude oil cost around $60 at the start of 2007, but at present (end-September 2011) the figure is loitering in the $110-115 range, having peaked at near $145 in 2008.

Yet in 2006 there was scepticism about pricing corporate acquisitions based on assumptions about the long-term price of oil staying above $40 for a sustained period. The recent rise in the oil price now far exceeds the extent of the 'oil shock' price rises in the 1970s.

What this means for investors is that there is money to be made in oil shares.

The larger companies, crawled over in some detail by analysts, are one thing. In their case, for integrated producers, extra profits made at the production end of the business might be offset in part by the higher cost of inputs to refineries and sluggish demand for finished products.

The smaller, 'junior', oil exploration and production stocks are a purer play on the oil price, and are much less well covered by analysts, leaving scope for mispricing by the market.

But a glance at the performance of a selection of junior oil companies shows sharp variations.

Dragon Oil (DGO) - one of the largest 'junior' oils has shown huge, if largely upward volatility, while (the rather smaller) Desire Petroleum () - the most privately-owned company on the stock exchange - has also flown. Many other stocks have risen by much smaller percentages and several have fallen by the wayside. So stock selection is crucial.

Conventional wisdom has it that junior oil stocks should be valued on a net present value basis, based on the cash flow expected to be produced by their assets, or on price to cash flow multiples. That is only of partial help, however, because many junior oils are at such an early stage in their development that they have negative cash flow, and this is likely to be a feature of their accounts for some time to come.

One other problem for companies that solely act as oil explorers is that a booming oil price will inevitably raise the cost of buying into exploration acreage. To neutralise this effect, companies need ideally to have a mix of exploration and production, and preferably also to have proven reserves already accurately delineated.

Implied price

One common way around the absence of cash flow to use as a valuation yardstick is to compare either enterprise value or market capitalisation with proven and probable oil reserves. In turn, you will arrive at some indication of the implied price that the market is putting on each barrel of oil or oil equivalent that the company has in the ground. One can then make a judgement about likely costs of extraction and apply a discount for the political risk involved in the area in which the company is operating.

The problem with this method is that companies are often reluctant to release sufficient data for this judgement to be made. With larger, better researched companies, it is less of a problem. But even if data is provided, untangling the precise interest owned and scale of reserves is not that easy.

Reserves that are proven and delineated are one thing. But in many cases analysts and investors have to deal with numbers for those reserves that are merely probable or forecast. Extensive training in petro-geology is needed to make sense of the data and the conventions governing the extent to which less certain and harder to extract reserves are discounted can be arcane.

One common rule is that, if you want to estimate potential recoverable reserves from a number for forecast reserves, simply multiply the latter figure by 0.2.

The simplest method of proceeding to a per share value for reserves is to go to the company's own announcements and attempt to find accurate figures for the company's interest in proven and probable reserves - better still if these figures are confirmed by subsequent press comment.

Firstly, heavily discount the value of any forecast reserves (as only a small fraction of these might in the event be recoverable), then multiply the result by the current oil price. The next step is to convert the company's market capitalisation or enterprise value (market capitalisation plus net debt or minus net cash) into dollars. This figure will almost always be less than the current value of reserves in the ground.

It then becomes a matter of exercising judgement.

One way is to compare the market value to 'oil in the ground' ratio between companies that have similar operating structures and country exposure. If this isn't available, then a judgement is required about the relative political risk involved. Oil in the ground in Canada might patently be worth more than oil in the ground in Nigeria - but what relative value can be put on oil in Nigeria versus oil in, say, Bangladesh?

Bear in mind, too, that the value of reserves and subsequent production can also be affected by the distance of the potential production from major world markets, and hence transport costs, and also particularly by the likely cost of extraction.

One way around the entire problem of course, is to buy shares in companies that service the oil exploration and production sector. Interestingly enough, the gains in share prices in this sector of the UK have been almost triple the rise in oil exploration stocks since the start of 2007.

Peter says

When I worked in the City, I had an expert colleague who who had worked for oil exploration and production companies. The result was that I was able to make money out of investing in shares like this, with big profits on Premier Oil (PMO) and Clyde Petroleum in particular, as I remember.

Since then, I have found it much more difficult to make judgements on oil companies. I have an equal blind spot about bank and insurance company shares.

But the variation in share price performance means that diversification and expert stock selection is required, which in turn means finding a fund that invests in companies like this. The alternative, for a simpler, more direct exposure, is to buy an oil price exchange traded commodity share - if you are confident the oil price will continue to rise.

The advantage of exposure to share prices, however, is that if the oil price continues to rise, there is a gearing inherent in E&P companies that isn't there in pure exposure to the commodity.