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Strategies & Market Trends : Value Investing

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To: Spekulatius who wrote (38962)	8/26/2010 1:18:15 AM
From: Spekulatius	2 Recommendations Read Replies (3) of 78470

I thought conceptionally about the E&P valuation and management efficiency a bit. One thing is clear - E&P cannot be valued based on their income statement or PE ratio or EV/EBITDA ratio. The reason for this is simple - the income statement is misleading because the proved reserves are always booked at cost. If we stick with a oil company it means that if an E&P incurred 10$ cost to find a BOE in the ground it would show up as a value of 10$ if the same BOE would cost 20$ ( a more inefficient operator) it would be valued at 20$. if course a barrel oil in the ground is a barrel, no matter how much money was spent to find it and it worth the same, but the balance sheet does not work that way. So, the way I look at things, we should forget about the income statement and just look at BOE rather than $. After all it is the E&P job to find more oil and eventually lift it and sell as a profit. So if you accept that BOE on the asset side is the important unit (rather than the arbitary US$ it costs to find them) then all that matters to calculate the ROA is to find out how much their reserve base increased during a year. So you essentially compare the prove reserves/share in Y2009 with the proved reserves Y2008 and the difference is the profit (in BOE) and the ROE would be BOE [(2009)-BOE (2008)]/BOE(2008). For simplicity let's assume they paid no dividends and invested all their cash flow): Example: A company start up in 2008 with 100m BOE and ends up with 110M BOE . They now have 10M BOE more than they started out with, so essentially their ROA (in BOE units) is 10%. The advantage of this method is that it does not matter how their got their - one company may have lifted 20M BOE but found 20MBOE new reserves for a net gain of 10M - another one may just have lifted 10M BOE and used the cash flow from that and found 20M BOE for a net gain 10M$ as well. Both companies would be worth the same but they probably would show a vastly different income or cash flow statement. Now in most cases, adjustments need to be done for dividend payments and free cash flow. Those adjustments should be done based on an agreed upon reserve valuation equivalent (I suggest 15$ for oil and 1.5$ for gas/MCFE If you look at a few examples (assuming I believe UPL's data) then CHK is a company with a lousy management because they have accomplished only a 4% reserve growth annualized over then years while paying minuscule dividends. UPL has grown their reserve base/share by 20% annualized so it's a vastly higher ROA company. Interesting enough CHK has much higher lower cash flow ratios and lower PE's so based on their income statement, they look much cheaper. What happens of course that most of this cash flow is blown back into operations to find new resources and it costs them about twice as much to do that than UPL. So, I think I have explained that in a rather clumsy manner, but for me that was sort of a revaluation so i wanted to put it down. Hopefully somebody else finds my reasoning useful.

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